**UNITED
        STATES SECURITIES AND EXCHANGE COMMISSION**
 **WASHINGTON,
        DC 20549**
 **FORM
        10-QSB**
 þ
              
              **QUARTERLY
                  REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
                  ACT OF
                  1934**
 **FOR
        THE QUARTERLY PERIOD ENDED March 31, 2007**
 o
              
              **TRANSITION
                  REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
                  ACT OF
                  1934**
 **For
        the transition period from to** **** **to** ****
 **Commission
        File Number: 001-32228**
 **O2DIESEL
        CORPORATION**
 (Name
        of
        small business issuer in its charter)
 Delaware
                (State
                  or Other
                Jurisdiction
                  of Incorporation)
              
              91-2023525
                (IRS
                  Employer
                Identification
                  No.)
 100
        COMMERCE DRIVE, Suite 301
 NEWARK,
        DELAWARE 19713
 (Address
        of Principal Executive Offices)
 (302) 266-6000
 (Issuer’s
        telephone number)
 Not
        Applicable
 (Former
        name, former address and former fiscal year, if changed since last
        report)
 Check
        whether the Issuer (1) filed all reports required to be filed by
        Section 13 or 15(d) of the
 Securities
        Exchange Act during the past 12 months (or for such shorter period that the
        registrant was
 required
        to file such reports), and (2) has been subject to such filing requirements
        for the past 90 days.
 Yes þ No o
 APPLICABLE
        ONLY TO CORPORATE ISSUERS
 Indicated
        by check mark whether the registrant is a shell company (as defined in
        Rule 12b-2 of the Exchange Act).
 Yes o No þ
 APPLICABLE
        ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE
        YEARS:
 Check
        whether the registrant filed all documents and reports required to be filed
        by
        Section 12, 13 or
 15(d)
        of
        the Exchange Act after the distribution of securities under a plan confirmed
        by
        the court.
 Yes o No o
 State
        the
        number of shares outstanding of each of the issuer’s classes of
        common
 equity,
        as of the latest practicable date:
 As
        of May
        8 ,
        2007,
        the registrant had 76,431,001 shares of Common Stock,
 $0.0001
        par value per share, issued and outstanding
 Transitional
        Small Business Disclosure Format (check one) Yes o No þ
  
 
 O2DIESEL
        CORPORATION
 FOR
        THE
        QUARTER ENDED March 31, 2007
 INDEX
        TO
        FORM 10-QSB
  PART
        I
        FINANCIAL INFORMATION
 Item 1.
                  Financial Statements
              
              
              F-1Item 2.
                  Management’s Discussion and Analysis or Plan of Operation
              
              
              1Item 3.
                  Controls and Procedures
              
              
              9PART
                  IIItem 1.
                  Legal Proceedings
              
              
              9Item 2.
                  Unregistered Sales of Equity Securities and Use of
                  Proceeds
              
              
              10Item 3.
                  Defaults Upon Senior Securities
              
              
              10Item 4.
                  Submission of Matters to a Vote of Security Holders
              
              
              10Item 5.
                  Other Information
              
              
              10Item 6.
                  Exhibits and Reports on Forms 8-K
              
              
              11Signatures
              
              
              11
 NOTE
        REGARDING FORWARD LOOKING STATEMENTS
 This
        quarterly report on Form 10-QSB contains forward-looking statements concerning
        O2Diesel Corporation (“O2Diesel,” the “Company” or the “Registrant”) and its
        future operations, plans and other matters. Any statements that involve
        discussions with respect to predictions, expectations, beliefs, plans,
        projections, objectives, assumptions or future events or performance (often,
        but
        not always, using phrases such as “expects”, or “does not expect”, “is
        expected”, “anticipates” or “does not anticipate”, “plans”, “estimates” or
“intends”, or stating that certain actions, events or results “may”, “could”,
“might”, or “will” be taken or occur or be achieved) are not statements of
        historical fact and may be “forward looking statements” which include statements
        relating to, among other things, the ability of O2Diesel to successfully
        compete
        in the fuel additive and fuel distribution business.
 
 O2Diesel
        cautions readers not to place undue reliance on any such forward-looking
        statements, which speak only as of the date made. Such forward-looking
        statements are based on the beliefs of O2Diesel’s management as well as on
        assumptions made by and information currently available to O2Diesel at the
        time
        such statements were made. Forward-looking statements are subject to a variety
        of risks and uncertainties which could cause actual events or results to
        differ
        from those reflected in the forward-looking statements, including, without
        limitation, the failure to obtain adequate financing on a timely basis and
        other
        risks and uncertainties. Actual results could differ materially from those
        projected in the forward-looking statements, as a result of either the matters
        set forth or incorporated in this report generally or certain economic and
        business factors, some of which may be beyond the control of O2Diesel. These
        factors include adverse economic conditions, entry of new and stronger
        competitors, inadequate capital, unexpected costs, failure to gain product
        approval in the United States or foreign countries for the commercialization
        and
        distribution of our products and failure to capitalize upon access to new
        markets and failure in obtaining the quality and quantity of ethanol necessary
        to produce our product at competitive prices. O2Diesel disclaims any obligation
        subsequently to revise any forward-looking statements to reflect events or
        circumstances after the date of such statements or to reflect the occurrence
        of
        anticipated or unanticipated events. “O2Diesel” and “CityHome” are trademarks of
        O2Diesel Corporation.
 
 
 
 O2Diesel
        Corporation
 (A
        Development Stage Company)
 PART
        I.
        FINANCIAL INFORMATION
 ITEM
        1.
 **Consolidated
        Balance Sheet**
 **March 31,
        2007**
 **ASSETS****CURRENT
                    ASSETS**Cash
                
                $
                1,532,621Restricted
                    cash
                
                
                3,226,966Accounts
                    receivable
                
                
                143,617Due
                    from related parties
                
                
                36,173Other
                    receivables
                
                
                610,571Unbilled
                    appropriations receivable
                
                
                237,660Inventory
                
                
                97,912Prepaid
                    expenses, parts and deposits
                
                
                241,868Total
                    current assets
                
                
                6,127,388**FURNITURE
                    AND EQUIPMENT**Office
                    furniture and equipment
                
                
                209,725Fuel
                    and test equipment
                
                
                213,350423,075Less
                    accumulated depreciation
                
                
                (210,471
                )212,604**TOTAL
                    ASSETS**
                
                ***$***
                ***6,339,992*****LIABILITIES
                    AND STOCKHOLDERS' EQUITY****CURRENT
                    LIABILITIES**Accounts
                    payable
                
                $
                834,703Accrued
                    expenses
                
                
                285,754Due
                    to related parties
                
                
                164,890Deferred
                    grants
                
                
                112,950Deferred
                    marketing program
                
                
                161,276Other
                    current liabilities
                
                
                8,632Total
                    current liabilities
                
                
                1,568,205**TOTAL
                    LIABILITIES**
                
                
                **1,568,205****STOCKHOLDERS'
                    EQUITY**Preferred
                    stock: par value of $0.0001; 20,000,000 shares authorized;none
                    issued and outstanding
                
                
                -Common
                    stock: par value of $0.0001; 135,000,000 shares
                    authorized;75,342,343
                    issued and outstanding
                
                
                7,534Additional
                    paid-in capital
                
                
                40,343,302Unearned
                    compensation
                
                
                (86,396
                )Accumulated
                    other comprehensive loss
                
                
                (1,679
                )Deficit
                    accumulated during the development stage
                
                
                (35,490,974
                )Total
                    stockholders' equity
                
                
                4,771,787**TOTAL
                    LIABILITIES AND STOCKHOLDERS' EQUITY**
                
                ***$***
                ***6,339,992***
 See
        Notes
        to Financial Statements
  F-1
 
 O2Diesel
        Corporation
 (A
        Development Stage Company)
 **Consolidated
        Statements of Operations**
 October
                    14, 2000(inception)Three
                    months ended March 31,
                
                through2007
                
                2006
                
                March
                    31, 2007**Revenue:**Additive
                    related sales
                
                $
                165,963
                
                $
                38,125
                
                $
                604,286Sponsorship
                    income
                
                
                15,750
                
                
                12,747
                
                
                163,623181,713
                
                
                50,872
                
                
                767,909**Expenses:**Cost
                    of goods sold
                
                
                131,381
                
                
                28,085
                
                
                457,688Selling
                    and marketing
                
                
                326,209
                
                
                244,850
                
                
                8,173,063Product
                    testing and government grants, net
                
                
                163,115
                
                
                37,337
                
                
                1,140,898General
                    and administrative
                
                
                2,033,275
                
                
                1,526,213
                
                
                27,582,305**Total
                    operating expense**
                
                
                2,653,980
                
                
                1,836,485
                
                
                37,353,954**Operating
                    loss**
                
                
                **(2,472,267**
                **)**
                
                **(1,785,613**
                **)**
                
                **(36,586,045**
                **)****Other
                    income (expense):**Interest
                    expense
                
                
                (1,853
                )
                
                (1,645
                )
                
                (124,376
                )Interest
                    income
                
                
                22,390
                
                
                3,177
                
                
                217,756Foreign
                    currency gain/(loss), net
                
                
                47,306
                
                
                69,592
                
                
                546,089Other
                    (expense)/income, net
                
                
                (110
                )
                
                (3,297
                )
                
                309,960**Total
                    other income (expense)**
                
                
                67,733
                
                
                67,827
                
                
                949,429**Loss
                    before provision (benefit) for income taxes**
                
                
                (2,404,534
                )
                
                (1,717,786
                )
                
                (35,636,616
                )Benefit
                    for income taxes
                
                
                -
                
                
                -
                
                
                145,642**Net
                    loss**
                
                
                **(2,404,534**
                **)**
                
                **(1,717,786**
                **)**
                
                **(35,490,974**
                **)****Deemed
                    dividend to preferred stockholders**
                
                
                **-**
                
                
                **(3,325,199**
                **)**
                
                **(6,200,005**
                **)****Net
                    loss allocable to common stockholders**
                
                **$**
                **(2,404,534**
                **)**
                **$**
                **(5,042,985**
                **)**
                **$**
                **(41,690,979**
                **)**Net
                    loss per common share(basic
                    and diluted)
                
                $
                (0.03
                )
                $
                (0.11
                )
                $
                (0.98
                )Weighted
                    average shares of commonshares
                    outstanding
                
                
                75,314,434
                
                
                46,891,018
                
                
                62,957,439Recapitalization
                    resulting from the AAETechnologies
                    International PLC acquisition
                
                
                -
                
                
                -
                
                
                (20,391,805
                )Weighted
                    average shares of commonshares
                    outstanding - giving effect to therecapitalization
                
                
                75,314,434
                
                
                46,891,018
                
                
                42,565,634
 See
        Notes
        to Financial Statements
  F-2
 
 O2Diesel
        Corporation
 (A
        Development Stage Company)
 **Consolidated
        Statement of Changes in Stockholders’ Equity (Deficit)**
 **October 14,
        2000 (Inception) through March 31, 2007**
 Common
                
                AdditionalPreferred
                    Stock
                
                Common
                    Stock
                
                Unearned
                
                Stock
                
                Paid
                    - InShares
                
                Amount
                
                Shares
                
                Amount
                
                Compensation
                
                Subscribed
                
                CapitalBalance
                    at October 14, 2000 (Inception)Common
                    stock issued in exchange for interest in wholly owned
                    subsidiaries
                
                
                -
                
                $
                -
                
                
                43,008,772
                
                $
                430,088
                
                $
                -
                
                $
                -
                
                $
                3,603,415Net
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -Foreign
                    currency translation adjustment
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -Comprehensive
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -Common
                    stock issued on various dates during 2001
                
                
                -
                
                
                -
                
                
                24,181,038
                
                
                241,810
                
                
                -
                
                
                -
                
                
                1,268,031Balance
                    at December 31, 2001
                
                
                -
                
                
                -
                
                
                67,189,810
                
                
                671,898
                
                
                -
                
                
                -
                
                
                4,871,446Net
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -Foreign
                    currency translation adjustment
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -Comprehensive
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -Common
                    stock issued at $0.225 per share on various dates during
                    2002
                
                
                -
                
                
                -
                
                
                703,282
                
                
                7,033
                
                
                -
                
                
                -
                
                
                515,657Balance
                    at December 31, 2002
                
                
                -
                
                
                -
                
                
                67,893,092
                
                
                678,931
                
                
                -
                
                
                -
                
                
                5,387,103Net
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -Foreign
                    currency translation adjustment
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -Comprehensive
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -Common
                    stock issued on various dates during 2003
                
                
                -
                
                
                -
                
                
                555,556
                
                
                5,556
                
                
                -
                
                
                -
                
                
                119,444Common
                    stock issued for consulting services
                
                
                -
                
                
                -
                
                
                200,000
                
                
                2,000
                
                
                -
                
                
                -
                
                
                43,000Common
                    stock issued for remaining interest in subsidiaries on July 15,
                    2003
                
                
                -
                
                
                -
                
                
                4,356,200
                
                
                43,562
                
                
                -
                
                
                -
                
                
                46,323Common
                    stock issued upon exercise of stock options on various dates
                    during
                    2003
                
                
                -
                
                
                -
                
                
                8,670,881
                
                
                86,709
                
                
                -
                
                
                -
                
                
                1,131,595Recapitalization
                    resulting from AAE acquisition on July 15, 2003
                
                
                -
                
                
                -
                
                
                (56,928,690
                )
                
                (814,283
                )
                
                -
                
                
                -
                
                
                814,283Common
                    stock issued at $1.50 per share on various dates during
                    2003
                
                
                -
                
                
                -
                
                
                3,333,333
                
                
                333
                
                
                -
                
                
                -
                
                
                4,999,667Expenses
                    related to 2003 issuance of common stock and
                    recapitalization
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (795,650
                )Subscriptions
                    for 754,900 shares of common stock at $1.50 per share on various
                    dates
                    during 2003
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                1,132,350
                
                
                -Balance
                    at December 31, 2003
                
                
                -
                
                
                -
                
                
                28,080,372
                
                
                2,808
                
                
                -
                
                
                1,132,350
                
                
                11,745,765Net
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -Foreign
                    currency translation adjustment
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -Comprehensive
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -Common
                    stock issued at $1.50 per share on various dates in 2004
                
                
                -
                
                
                -
                
                
                1,070,451
                
                
                107
                
                
                -
                
                
                (1,132,350
                )
                
                1,535,770Preferred
                    stock issued on various dates during 2004
                
                
                1,550,000
                
                
                155
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                5,478,609Balance
                    at December 31, 2004
                
                
                1,550,000
                
                
                155
                
                
                29,150,823
                
                
                2,915
                
                
                -
                
                
                -
                
                
                18,760,144Net
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -Foreign
                    currency translation adjustment
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -Comprehensive
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -Common
                    stock issued for consulting services
                
                
                -
                
                
                -
                
                
                63,750
                
                
                6
                
                
                -
                
                
                -
                
                
                63,094Warrants
                    issued for consulting services
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                135,000Common
                    stock issued at $0.70 per share on various dates in 2005
                
                
                -
                
                
                -
                
                
                7,515,981
                
                
                752
                
                
                -
                
                
                -
                
                
                4,832,439Common
                    stock issued at $0.7125 per share on various dates in 2005
                
                
                -
                
                
                -
                
                
                3,228,070
                
                
                322
                
                
                -
                
                
                -
                
                
                2,090,178Common
                    stock issued at $0.564 per share on various dates in 2005
                
                
                -
                
                
                -
                
                
                6,419,840
                
                
                642
                
                
                -
                
                
                -
                
                
                3,599,658Balance
                    at December 31, 2005
                
                
                1,550,000
                
                
                155
                
                
                46,378,464
                
                
                4,637
                
                
                -
                
                
                -
                
                
                29,480,513Net
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -Foreign
                    currency translation adjustment
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -Comprehensive
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -Common
                    stock issued via exercise of warrants on various dates in
                    2006
                
                
                -
                
                
                -
                
                
                3,151,892
                
                
                315
                
                
                -
                
                
                -
                
                
                1,457,829Common
                    stock issued for consulting services
                
                
                -
                
                
                -
                
                
                56,250
                
                
                6
                
                
                -
                
                
                -
                
                
                50,994Conversion
                    of preferred stock into common stock on various dates in
                    2006
                
                
                (1,550,000
                )
                
                (155
                )
                
                15,500,000
                
                
                1,550
                
                
                -
                
                
                -
                
                
                (1,395
                )Common
                    stock issued at $0.75 per share in 2006
                
                
                -
                
                
                -
                
                
                8,666,666
                
                
                867
                
                
                -
                
                
                -
                
                
                6,256,282Common
                    stock issued at $0.729 per share in 2006
                
                
                -
                
                
                -
                
                
                1,371,742
                
                
                138
                
                
                -
                
                
                -
                
                
                979,367Fair
                    value of unvested stock options upon adoption of SFAS 123
                    R
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (376,031
                )
                
                -
                
                
                376,031Amortization
                    of unearned compensation
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                250,890
                
                
                -
                
                
                -Fair
                    value of stock options issued in 2006
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                1,476,684Balance
                    at December 31, 2006
                
                
                -
                
                
                -
                
                
                75,125,014
                
                
                7,513
                
                
                (125,141
                )
                
                -
                
                
                40,076,305Net
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -Foreign
                    currency translation adjustment
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -Comprehensive
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -Common
                    stock issued to employee
                
                
                -
                
                
                -
                
                
                166,667
                
                
                17
                
                
                -
                
                
                -
                
                
                136,650Fair
                    value of unearned shares related to commitment shares
                
                
                -
                
                
                -
                
                
                805,987
                
                
                80
                
                
                -
                
                
                -
                
                
                668,969Unearned
                    common stock issued for commitment shares
                
                
                -
                
                
                -
                
                
                (755,325
                )
                
                (76
                )
                
                -
                
                
                -
                
                
                (626,919
                )Amortization
                    of unearned compensation
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                38,745
                
                
                -
                
                
                -Fair
                    value of stock options issued in 2006
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                88,297Balance
                    at March 31, 2007
                
                
                -
                
                $
                -
                
                
                75,342,343
                
                $
                7,534
                
                $
                (86,396
                )
                
                -
                
                $
                40,343,302
 See
          Notes
          to Financial Statements
 
 F-3
 
 O2Diesel
        Corporation
 (A
        Development Stage Company)
 **Consolidated
        Statement of Changes in Stockholders’ Equity (Deficit)**
 **October 14,
        2000 (Inception) through March 31, 2007**
 DeficitCommon
                
                Accumulated
                
                Accumulated
                
                TotalStock
                
                Other
                
                During
                    the
                
                Stockholders'Subscriptions
                
                Comprehensive
                
                Development
                
                EquityReceivable
                
                Income
                    (Loss)
                
                Stage
                
                (Deficit)Balance
                    at October 14, 2000 (Inception)Common
                    stock issued in exchange for interest in wholly owned
                    subsidiaries
                
                $
                -
                
                $
                -
                
                $
                (4,138,684
                )
                $
                (105,181
                )Net
                    loss
                
                
                -
                
                
                -
                
                
                (1,406,709
                )
                
                (1,406,709
                )Foreign
                    currency translation adjustment
                
                
                -
                
                
                (4,476
                )
                
                -
                
                
                (4,476
                )Comprehensive
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                (1,411,185
                )Common
                    stock issued on various dates during 2001
                
                
                -
                
                
                -
                
                
                -
                
                
                1,509,841Balance
                    at December 31, 2001
                
                
                -
                
                
                (4,476
                )
                
                (5,545,393
                )
                
                (6,525
                )Net
                    loss
                
                
                -
                
                
                -
                
                
                (1,712,803
                )
                
                (1,712,803
                )Foreign
                    currency translation adjustment
                
                
                -
                
                
                (74,085
                )
                
                -
                
                
                (74,085
                )Comprehensive
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                (1,786,888
                )Common
                    stock issued at $0.225 per share on various dates during
                    2002
                
                
                -
                
                
                -
                
                
                -
                
                
                522,690Balance
                    at December 31, 2002
                
                
                -
                
                
                (78,561
                )
                
                (7,258,196
                )
                
                (1,270,723
                )Net
                    loss
                
                
                -
                
                
                -
                
                
                (4,230,296
                )
                
                (4,230,296
                )Foreign
                    currency translation adjustment
                
                
                -
                
                
                179,689
                
                
                -
                
                
                179,689Comprehensive
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                (4,050,607
                )Common
                    stock issued on various dates during 2003
                
                
                -
                
                
                -
                
                
                -
                
                
                125,000Common
                    stock issued for consulting services
                
                
                -
                
                
                -
                
                
                -
                
                
                45,000Common
                    stock issued for remaining interest in subsidiaries on July 15,
                    2003
                
                
                -
                
                
                -
                
                
                (409,614
                )
                
                (319,729
                )Common
                    stock issued upon exercise of stock options on various dates
                    during
                    2003
                
                
                -
                
                
                -
                
                
                -
                
                
                1,218,304-Recapitalization
                    resulting from AAE acquisition on July 15, 2003
                
                
                -
                
                
                -
                
                
                -
                
                
                -Common
                    stock issued at $1.50 per share on various dates during
                    2003
                
                
                -
                
                
                -
                
                
                -
                
                
                5,000,000Expenses
                    related to 2003 issuance of common stock and
                    recapitalization
                
                
                -
                
                
                -
                
                
                -
                
                
                (795,650
                )Subscriptions
                    for 754,900 shares of common stock at $1.50 per share on various
                    dates
                    during 2003
                
                
                (180,000
                )
                
                -
                
                
                -
                
                
                952,350Balance
                    at December 31, 2003
                
                
                (180,000
                )
                
                101,128
                
                
                (11,898,106
                )
                
                903,945Net
                    loss
                
                
                -
                
                
                -
                
                
                (6,728,014
                )
                
                (6,728,014
                )Foreign
                    currency translation adjustment
                
                
                -
                
                
                (97,446
                )
                
                -
                
                
                (97,446
                )Comprehensive
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                (6,825,460
                )Common
                    stock issued at $1.50 per share on various dates in 2004
                
                
                180,000
                
                
                -
                
                
                -
                
                
                583,527Preferred
                    stock issued on various dates during 2004
                
                
                -
                
                
                -
                
                
                -
                
                
                5,478,764Balance
                    at December 31, 2004
                
                
                -
                
                
                3,682
                
                
                (18,626,120
                )
                
                140,776Net
                    loss
                
                
                -
                
                
                -
                
                
                (6,852,165
                )
                
                (6,852,165
                )Foreign
                    currency translation adjustment
                
                
                -
                
                
                2,329
                
                
                -
                
                
                2,329Comprehensive
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                (6,849,836
                )Common
                    stock issued for consulting services
                
                
                -
                
                
                -
                
                
                -
                
                
                63,100Warrants
                    issued for consulting services
                
                
                -
                
                
                -
                
                
                -
                
                
                135,000Common
                    stock issued at $0.70 per share on various dates in 2005
                
                
                -
                
                
                -
                
                
                -
                
                
                4,833,191Common
                    stock issued at $0.7125 per share on various dates in 2005
                
                
                -
                
                
                -
                
                
                -
                
                
                2,090,500Common
                    stock issued at $0.564 per share on various dates in 2005
                
                
                -
                
                
                -
                
                
                -
                
                
                3,600,300Balance
                    at December 31, 2005
                
                
                -
                
                
                6,011
                
                
                (25,478,285
                )
                
                4,013,031Net
                    loss
                
                
                -
                
                
                -
                
                
                (7,608,155
                )
                
                (7,608,155
                )Foreign
                    currency translation adjustment
                
                
                -
                
                
                (10,392
                )
                
                -
                
                
                (10,392
                )Comprehensive
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                (7,618,547
                )Common
                    stock issued via exercise of warrants on various dates in
                    2006
                
                
                -
                
                
                -
                
                
                -
                
                
                1,458,144Common
                    stock issued for consulting services
                
                
                -
                
                
                -
                
                
                -
                
                
                51,000Conversion
                    of preferred stock into common stock on various dates in
                    2006
                
                
                -
                
                
                -
                
                
                -
                
                
                -Common
                    stock issued at $0.75 per share in 2006
                
                
                -
                
                
                -
                
                
                -
                
                
                6,257,149Common
                    stock issued at $0.729 per share in 2006
                
                
                -
                
                
                -
                
                
                -
                
                
                979,505Fair
                    value of unvested stock options upon adoption of SFAS 123
                    R
                
                
                -
                
                
                -
                
                
                -
                
                
                -Amortization
                    of unearned compensation
                
                
                -
                
                
                -
                
                
                -
                
                
                250,890Fair
                    value of stock options issued in 2006
                
                
                -
                
                
                -
                
                
                -
                
                
                1,476,684Balance
                    at December 31, 2006
                
                
                -
                
                
                (4,381
                )
                
                (33,086,440
                )
                
                6,867,856Net
                    loss
                
                
                -
                
                
                -
                
                
                (2,404,534
                )
                
                (2,404,534
                )Foreign
                    currency translation adjustment
                
                
                -
                
                
                2,702
                
                
                -
                
                
                2,702Comprehensive
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                (2,401,832
                )Common
                    stock issued to employee
                
                
                -
                
                
                -
                
                
                -
                
                
                136,667Fair
                    value of unearned shares related to commitment shares
                
                
                -
                
                
                -
                
                
                -
                
                
                669,049Unearned
                    common stock issued for commitment shares
                
                
                -
                
                
                -
                
                
                -
                
                
                (626,995
                )Amortization
                    of unearned compensation
                
                
                -
                
                
                -
                
                
                -
                
                
                38,745Fair
                    value of stock options issued in 2006
                
                
                -
                
                
                -
                
                
                -
                
                
                88,297Balance
                    at March 31, 2007
                
                $
                -
                
                $
                (1,679
                )
                $
                (35,490,974
                )
                $
                4,771,787
 See
          Notes
          to Financial Statements
  F-4
 
 O2Diesel
        Corporation
 (A
        Development Stage Company)
 **Consolidated
        Statements of Cash Flows**
 October
                    14, 2000Three
                    Months Ended March 31,
                
                (inception)
                    through2007
                
                2006
                
                March
                    31, 2007**Cash
                    flows from operating activites****Net
                    loss**
                
                **$**
                **(2,404,534**
                **)**
                **$**
                **(1,717,786**
                **)**
                **$**
                **(35,490,974**
                **)**Adjustments
                    to reconcile loss to net cash used in operating activites:Depreciation
                
                
                21,595
                
                
                20,916
                
                
                305,359Amortization
                
                
                -
                
                
                -
                
                
                7,786Write
                    off of patent
                
                
                -
                
                
                -
                
                
                337,329Write
                    off of obsolete inventory
                
                
                -
                
                
                -
                
                
                5,925Loss(Gain)
                    on sale/disposal of furniture & equipment
                
                
                -
                
                
                850
                
                
                8,528Non
                    cash contributions
                
                
                -
                
                
                1,564
                
                
                5,312Common
                    stock and warrants issued for consulting services
                
                
                -
                
                
                14,625
                
                
                254,100Common
                    stock issued to employee
                
                
                136,667
                
                
                -
                
                
                136,667Common
                    stock issued for commitment shares
                
                
                42,054
                
                
                -
                
                
                42,054Amortization
                    of unearned compensation
                
                
                127,042
                
                
                100,356
                
                
                1,854,616Changes
                    in operating assets and liabilites:Accounts
                    receivable
                
                
                (129,842
                )
                
                6,750
                
                
                (143,617
                )Due
                    from/(to) related parties
                
                
                23,596
                
                
                83,731
                
                
                128,717Other
                    receivables
                
                
                122,016
                
                
                (50,457
                )
                
                (610,571
                )Inventory,
                    prepaid expenses and other current assets
                
                
                (103,489
                )
                
                (73,999
                )
                
                (583,365
                )Accounts
                    payable
                
                
                284,811
                
                
                158,296
                
                
                834,703Accrued
                    expenses
                
                
                (100,913
                )
                
                (68,881
                )
                
                285,754Deferred
                    grants
                
                
                102,991
                
                
                199,099
                
                
                112,950Deferred
                    marketing program
                
                
                (73,224
                )
                
                (64,811
                )
                
                161,276Other
                    current liabilities
                
                
                2,070
                
                
                882
                
                
                (2,526
                )**Cash
                    flows used in operating activities**
                
                
                **(1,949,160**
                **)**
                
                **(1,388,865**
                **)**
                
                **(32,349,977**
                **)****Cash
                    flows from investing activities**Restricted
                    cash
                
                
                417,461
                
                
                (66,121
                )
                
                (3,226,966
                )Purchase
                    of furniture and equipment
                
                
                (4,012
                )
                
                (41,702
                )
                
                (532,893
                )Proceeds
                    from sale of furniture & equipment
                
                
                -
                
                
                -
                
                
                13,150Purchase
                    of patent
                
                
                -
                
                
                -
                
                
                (345,115
                )**Cash
                    flows provided by (used in) investing activities**
                
                
                **413,449**
                
                
                **(107,823**
                **)**
                
                **(4,091,824**
                **)****Cash
                    flows from financing activities**Net
                    proceeds from issuance of preferred stock
                
                
                -
                
                
                -
                
                
                5,478,764Net
                    proceeds from private placement
                
                
                -
                
                
                -
                
                
                5,953,757Net
                    proceeds from issuance of common stock
                
                
                -
                
                
                592,692
                
                
                26,550,493**Cash
                    flows provided by financing activities**
                
                
                **-**
                
                
                **592,692**
                
                
                **37,983,014**Effect
                    of exchange rate changes on cash
                
                
                2,702
                
                
                1,981
                
                
                (8,592
                )**Net
                    (decrease)/increase in cash**
                
                
                **(1,533,009**
                **)**
                
                **(902,015**
                **)**
                
                **1,532,621****Cash
                    at beginning of period**
                
                
                **3,065,630**
                
                
                **1,412,851**
                
                
                **-****Cash
                    at end of period**
                
                **$**
                **1,532,621**
                
                **$**
                **510,836**
                
                **$**
                **1,532,621**Cash
                    paid for interest
                
                $
                1,853
                
                $
                1,645
                
                $
                115,024Cash
                    paid for income taxes
                
                
                None
                
                
                None
                
                
                None
 
 Non-cash
        transactions: Conversion of Bridge loan to common stock at 9/30/2003,
        $2,322,500.
 Conversion
        of preferred to common stock at various dates during 2006,
        $1,550,000.
   See
        Notes
        to Financial Statements
  F-5
 
 O2Diesel
        Corporation
 (A
        Development Stage Company)
 Notes
        to
        Financial Statements
 **1.
        The Company and Basis of Presentation**
 
 **The
        Company**
 
 O2Diesel
        Corporation (“O2Diesel” or the “Company”) is in the development stage and has
        developed a proprietary additive product designed to enable distillate liquid
        transportation fuels to burn cleaner by facilitating the addition of ethanol
        as
        an oxygenate to these fuels. To date, the Company’s operations have continued to
        be focused on raising capital, performing research and development, and bringing
        its product to market.
 
 O2Diesel
        Corporation’s predecessor, Dynamic Ventures, Inc., was incorporated in the State
        of Washington on April 24, 2000. Dynamic Ventures, Inc. changed its name to
        O2Diesel Corporation effective June 10, 2003, in contemplation of the
        reverse acquisition of AAE Technologies International Plc (AAE). On
        July 15, 2003, O2Diesel Corporation acquired all of the issued and
        outstanding shares of AAE in exchange for 17,847,039 shares of its common
        stock.
        As a result of this transaction, the former shareholders of AAE acquired
        control
        of the combined companies. The acquisition of AAE has been accounted for
        as a
        capital transaction followed by a recapitalization. AAE was considered to
        be the
        accounting acquirer. Accordingly, the historical financial statements of
        AAE are
        considered to be those of O2Diesel Corporation for all periods
        presented.
 
 In
        conjunction with the reverse acquisition, the Company completed a private
        placement of its common stock whereby it issued 3,333,333 shares of common
        stock
        at $1.50 per share. Of the $5.0 million raised, approximately $800,000 was
        used
        to pay the costs of the reverse acquisition and private placement,
        $1.0 million was used to repay a bridge loan that was made in contemplation
        of the transaction, and the balance of $3.2 million was used to fund the
        ongoing developmental activities of the Company. Subsequent to its first
        private
        placement, the Company undertook to raise an additional $3.5 million
        through a follow-on private placement of our common stock (the “Follow-On
        Private Placement”). In the Follow-On Private Placement, we raised $1,535,770,
        before expenses, and issued 1,025,784 shares of our common stock at a price
        of
        $1.50 per share.
 
 O2Diesel
        was reincorporated in the state of Delaware in a transaction that became
        effective on December 31, 2004.
 
 On
        June 15, 2004, the American Stock Exchange (“AMEX” or “Exchange”) approved
        an application to list 46,518,898 shares of our common stock under the symbol
        OTD. Subsequent to this date, the Exchange has approved additional applications
        to list 60,849,310 shares of the Company’s common stock so that the total number
        of shares approved for listing is now 107,368,208. Our shares began to trade
        on
        the exchange on July 1, 2004.
 
 **Basis
        of Presentation**
 
 The
        Company’s unaudited consolidated financial statements for the three months ended
        March 31, 2007, have been prepared on a going concern basis, which
        contemplates the realization of assets and the settlement of liabilities
        and
        commitments in the normal course of business. At March 31, 2007, the
        Company had working capital of $4,559,183 and had accumulated losses of
        $35,490,974.
 
 Further,
        the Company was notified in December 2004 by the AMEX that it was not in
        compliance with the listing standards of the Exchange because it lacked the
        requisite amount of stockholders’ equity. AMEX requires that minimum levels of
        stockholders’ equity be maintained. O2Diesel was not in compliance because its
        stockholders’ equity had dropped below the required minimums, and it had
        experienced continuing losses for the past four years. In order to return
        to
        full compliance, O2Diesel needed to have stockholders’ equity of
        $6.0 million by June 2006 and to maintain this level going
        forward.
 
 In
        accordance with the procedures of the Exchange, we filed a plan (“Plan”) with it
        to demonstrate the steps we would take to return to full compliance. On
        February 15, 2005, the AMEX notified us that it had accepted our Plan, and
        that we would be given until June 2006 in which to regain compliance with
        the Exchange’s listing rules. To achieve that level of stockholders’ equity, we
        anticipated having to raise a total of approximately $10.0 million in new
        equity during 2005. In December 2005 the Company determined that it could
        not meet certain conditions of the Plan and met with representatives of the
        AMEX
        to discuss the need to develop an amended plan to demonstrate how the Company
        would be in compliance by June 2006.
 
 The
        Company believed it needed to raise an additional $7.0 million in new
        capital prior to June 2006 to allow it to return to full compliance with
        the listing standards of the AMEX. In addition, the Company believed it needed
        to raise an additional $3.5 million in equity in the second half of 2006 to
        allow it to execute its business plan for the year and to remain in compliance
        with the AMEX standards.
 
 As
        described later in this section, the Company collected $592,692 (after expenses)
        and $865,452 (net of expenses) in two warrant exercises and closed three
        private
        placements totaling $7.5 million as part of this effort. The consolidated
        financial statements in this report do not include any adjustments to reflect
        the anticipated private placements or the possible future effects on the
        recoverability and classification of assets or the amounts and classification
        of
        liabilities that may result should management be unsuccessful in obtaining
        financing on terms acceptable to the Company.
 
 F-6
 
 O2Diesel
        Corporation
 (A
        Development Stage Company)
 Notes
        to
        Financial Statements
 
 On
        July
        17, 2006, the Company received a letter from the AMEX indicating that the
        Company had regained compliance with AMEX listing requirements. At December
        31,
        2006, the Company was in compliance with AMEX listing requirements, but for
        period ended March 31, 2007, the Company was not able to meet the listing
        requirements. However, as described later in this section, the Company has
        entered into a common stock purchase agreement to raise up to $10 million
        in new
        equity in 2007, which we believe will enable us to meet or exceed these
        requirements, once the registration statement for such shares is effective.
 
 If
        the
        Company were to fail to return to full compliance with the Exchange’s listing
        standards, the AMEX would likely initiate procedures to de-list the Company’s
        common stock. If the Company’s common stock were to be de-listed by the AMEX,
        its shares would continue to be traded as a bulletin board stock.
 
 Since
        July 2003, the Company has raised approximately $33 million for its
        operations.
 
 **Transactions
        During the First Quarter of 2007**
  **ProEco
        Transaction**
 
 On
        January 12, 2007, the Company entered into a share exchange agreement (the
        “Share Exchange Agreement”) with ProEco Energy Company, Inc. (“ProEco”) and its
        shareholders (“ProEco Shareholders”) to acquire shares equal to 80% of the
        outstanding capital stock of ProEco in exchange for approximately 9.2 million
        shares of the Company’s common stock (the “Transaction Shares”) valued at $0.872
        per share for a total purchase price of $8.0 million.
 
 ProEco,
        which has had limited operations to date, is in the process of developing
        a new
        fuel-grade ethanol plant (the “Ethanol Plant”) with planned capacity of 100
        million gallons per year to be built in two 50 million gallon trains (each
        a
“Train”). ProEco Shareholders will receive 60% of the Transaction Shares at the
        time of the closing and will receive the remaining 40% of the Transaction
        Shares
        in two equal installments upon the completion of construction of the first
        Train
        (20%) and the commencement of construction of the final Train (20%). The
        remaining 40% of the Transaction Shares will be held in escrow until the
        conditions for their release have been met. The parties intend the transaction
        to qualify as a tax-free reorganization under Section 368(a) of the U.S.
        Internal Revenue Code of 1986, as amended.
 
 The
        Share
        Exchange Agreement requires ProEco to complete a number of steps toward
        completion of the Ethanol Plant project in order for the closing of the share
        exchange to occur. At the time of the closing, ProEco must have entered into
        a
        definitive engineering, procurement and construction contract with a reputable
        firm with extensive experience in implementing and completing projects similar
        to the Ethanol Plant project and executed marketing agreements for the sale
        of
        the production of the Ethanol Plant. Under the terms of the share exchange
        agreement, ProEco is responsible for having the Ethanol Plant designated
        as a
        facility nameplated, or certified, as producing ethanol at a level of at
        least
        100 million gallons of production a year.
 
 As
        a
        condition to the closing of the ProEco share exchange, the Company is obligated
        to secure the financing necessary to complete the construction costs to build
        the Ethanol Plant. Accordingly, the Company will be required to raise $120
        to
        $140 million in debt and between $60 and $80 million in equity in two tranches
        in 2007.
 
 Prior
        to
        closing, the Company and the ProEco Shareholders will enter into a stockholder
        agreement that will, among other things, impose restrictions on the transfer
        of
        the Transaction Shares.
 
 The
        Common Stock will be issued to the ProEco shareholders in a transaction that
        will be exempt from the registration requirement pursuant to Section 4(2)
        of the
        Securities Act of 1933, as amended (the “Securities Act”) and under Regulation D
        promulgated under the Securities Act.
  Under
          the
          terms of the letter of intent for the share exchange agreement, the Company
          agreed to enter into a secured loan agreement with ProEco for the purposes
          of
          financing the purchase options for the land to be used for the ethanol
          plant and
          certain engineering and permitting work required for the closing of the
          ProEco
          share exchange. The loan agreement provides for the Company to advance
          ProEco up to $400,000 and has a maturity date of June 22, 2007. The
          interest rate on the loan is 7%. As of March 31, 2007, the Company had
          advanced
          $400,000 to ProEco under the terms of this agreement. As of April 30, 2007,
          the
          Company agreed to extend the maturity date of the loan to September 15,
          2007.
 
 **$10
        million Private Placement**
 
 On
        February 16, 2007, the Company entered into a common stock purchase agreement
        (the “Purchase Agreement”) with Fusion Capital Fund II, LLC, an Illinois limited
        liability company (“Fusion Capital”). Pursuant to the Purchase Agreement, at the
        Company’s discretion, the Company may sell up to $10 million of the Company’s
        common stock to Fusion Capital from time to time over a 25-month period.
        The
        Company has reserved for issuance up to 12,000,000 shares of the Company’s
        common stock for sale to Fusion Capital under this agreement. Subject to
        earlier
        termination at the Company’s discretion, Fusion Capital’s purchase will occur
        after the Securities and Exchange Commission ("SEC") has declared effective
        the
        registration statement related to the transaction. The Company has issued
        to
        Fusion Capital 805,987 shares of the Company’s common stock as a commitment fee
        for entering into the Purchase Agreement.
  F-7
 
 O2Diesel
        Corporation
 (A
        Development Stage Company)
 Notes
        to
        Financial Statements
  Concurrently
        with entering into the Purchase Agreement, the Company entered into a
        registration rights agreement with Fusion Capital (the “Registration Rights
        Agreement”). Under the Registration Rights Agreement, the Company agreed to file
        a registration statement with the SEC covering the shares that have been
        issued
        or may be issued to Fusion Capital under the Purchase Agreement. After the
        SEC
        has declared effective the registration statement, generally the Company
        has the
        right but not the obligation from time to time to sell shares of the Company’s
        common stock to Fusion Capital in amounts between $100,000 and $1 million
        depending on certain conditions. The Company has the right to control the
        timing
        and amount of any sales of the Company’s shares to Fusion Capital. The purchase
        price of the shares will be determined based upon the market price of the
        shares
        of common stock without any fixed discount. Fusion Capital shall not have
        the
        right or the obligation to purchase any shares of the Company’s common stock on
        any business day that the price of the Company’s common stock is below either
        $0.50 or $0.60, depending on the transaction size of the purchase. The agreement
        may be terminated by the Company at any time at its discretion without any
        cost
        to the Company.
 
 **2.
        Summary of Significant Accounting Policies**
 
 **Principles
        of Consolidation**
 
 The
        consolidated financial statements include the accounts of the Company and
        all
        affiliated subsidiaries. All significant inter-company balances and transactions
        have been eliminated in consolidation.
 
 **Cash
        and Cash Equivalents**
 
 The
        Company considers all highly liquid instruments with a maturity of three
        months
        or less at the time of issuance to be cash equivalents. As of March 31,
        2007 cash deposits exceeded federally insured limits which are generally
        $100,000 per financial institution.
 
 **Restricted
        Cash**
 
 On
        December 16, 2005, the Company completed a private placement of its common
        stock, whereby it received approximately $3.6 million USD which is
        restricted to operational costs associated with developing markets in Europe.
        Prior to 2005, restricted cash consisted of cash held in the Company’s bank
        account pursuant to the provisions set forth in documents to the acquisition
        of
        AAE on July 15, 2003. The restricted funds associated with the acquisition
        of AAE were released in equal amounts on October 15, 2003, and
        January 15, 2004.
 
 **Concentration
        of Credit Risk and Allowance for Doubtful Accounts**
 
 The
        Company provides an allowance for doubtful accounts for estimated losses
        resulting from the inability of customers to make required payments. The
        Company
        does not require collateral and it does not charge finance fees on outstanding
        trade receivables. The allowance is determined by analyzing historical data
        and
        trends, as well as specific customers’ financial conditions. Past-due or
        delinquency status is based upon the credit terms for that specific customer
        from the date of delivery. Charges for doubtful accounts are recorded in
        selling
        and marketing expenses. Trade accounts receivables are written off against
        the
        allowance for doubtful accounts when collection appears unlikely.
 
 **Inventories**
 
 Inventories,
        consisting of fuel additive held at third party locations, are stated at
        the
        lower of cost as determined using the first in, first out (FIFO) method, or
        market value.
 
 **Furniture
        and Equipment and Depreciation**
 
 Furniture
        and equipment are stated at cost, less accumulated depreciation. Depreciation
        is
        provided over the estimated useful lives of the assets using the straight-line
        method. The estimated useful lives of fixed assets are as follows:
 
 Office
        furniture and equipment: 3 to 5 years
 Fuel
        and
        test equipment: 5 years
 
 Depreciation
        expense recorded in the accompanying Consolidated Statements of Operations
        was
        $21,595 and $20,916, respectively for the three months ended March 31, 2007
        and 2006, and was $305,359 respectively for the period October 14, 2000
        (inception) through March 31, 2007.
  F-8
  O2Diesel
        Corporation
 (A
        Development Stage Company)
 Notes
        to
        Financial Statements
 
 **Accounting
        for Impairment of Long-Lived Assets**
 
 The
        carrying values of intangible assets and other long-lived assets are reviewed
        on
        a regular basis for the existence of facts or circumstances that may suggest
        impairment. The Company recognizes impairment when the sum of the expected
        undiscounted future cash flows is less than the carrying amount of the asset.
        Impairment losses, if any, are measured as the excess of the carrying amount
 of
        the
        asset over its estimated fair value.
 
 **Financial
        Instruments**
 
 The
        carrying value of cash, accounts receivable, due to/from related parties,
        and
        accounts payable approximate fair value due to the relatively short maturity
        of
        these instruments.
 
 **Revenue
        Recognition**
 
 The
        Company sells its product directly to its customers and revenue is recognized
        and recorded upon the passage of title of the product to the customer and
        following confirmation that the customer is utilizing the final blended
        fuel.
 
 The
        Company has developed the CityHomeTM program to serve as a key element of its
        sales/marketing and product demonstration strategy. This program involves
        the
        sale of our additive, the receipt of sponsorship fees and the potential sale
        of
        advertising space. As with other customers, revenue from the sales of product
        is
        recognized and recorded upon the passage of title of the product to the customer
        and following confirmation that the customer is utilizing the final blended
        fuel. Sponsorship fees will become additional revenue for us and will be
        recognized as such over the period of the contract when a sponsorship agreement
        is signed and the fees have been invoiced and payment has been assured. Costs
        that are intended to be supported by the sponsorship fees are recorded
        separately in the related expense line in our statement of operations. With
        regard to the advertising space, since the CityHomeTM program is still in a
        relatively undeveloped phase and since we have been unable to assess the
        fair
        market value of the advertising space received, we assign no value to the
        space
        at the time of receipt. We are recognizing the value associated with the
        advertising space when we enter into a contract arrangement with a third
        party.
        The Company will consider assigning a fair value to the advertising space
        received at the time of the initial sale when such fair value is more readily
        determinable, based upon a history of cash transactions.
 
 The
        Company has supported certain fleet equipment conversion costs in these
        CityHomeTM initiatives and has also been required to bear the incremental costs
        of the blended fuel, where it is experienced. Whenever the expected costs
        of the
        program are determined to be in excess of the contracted sponsorship fees
        and
        related fuel additive revenue, the Company records the loss for the contract
        as
        an expense and a deferred liability to be amortized over the life of the
        contract. As of March 31, 2007, costs remaining to be amortized for
        CityHomeTM programs were recorded on the balance sheet as Deferred Marketing
        Program in the amount of $161,276. The Company recorded $17,059 in costs
        for the
        CityHomeTM initiatives in excess of sponsorship fees during the quarter ended
        March 31, 2007 and $19,273 and $1,138,795 of costs in excess of sponsorship
        fees for CityHomeTM initiatives for the quarter ended March 31, 2006 and for
        the October 14, 2000 (inception) through March 31, 2007,
        respectively.
 
 **Shipping
        and Handling Costs**
 
 The
        Company classifies costs associated with shipping and handling activities
        within
        cost of goods sold in the consolidated statements of operations. Shipping
        and
        handling costs were $10,205 for the three months ended March 31, 2007 and
        were $2,937 and $61,897 respectively for the three months March 31, 2006
        and for the period October 14, 2000 (inception) through March 31,
        2007.
 
 **Advertising
        Expenses**
 
 Advertising
        costs are expensed as incurred. Advertising expense was $0, $0 and $450,000
        for
        the three months ended March 31, 2007, and 2006, and the period October 14,
        2000 (inception) through December 31, 2006, respectively.
 
 **Research
        and Development Costs**
 
 Research
        and development costs are expensed as incurred.
 
 **Product
        Test and Demonstration Appropriations**
 
 The
        Company receives appropriations from U.S. governmental agencies to fund certain
        of its product testing and demonstration programs. The Company evaluates
        the
        conditions of the appropriation and either increases revenue, decreases expenses
        or reduces the cost of furniture and equipment depending upon the attributes
        of
        the underlying grant. Appropriations are not recognized until there is
        reasonable assurance that the Company will comply with the conditions of
        the
        grant and that the monies under the grant will be received.
 
 F-9
 
 O2Diesel
        Corporation
 (A
        Development Stage Company)
 Notes
        to
        Financial Statements
 
 **Net
        Loss Per Common Share (Basic and Diluted)**
  Basic
        net
        loss per common share is computed by dividing the net loss available to common
        stockholders by the weighted average number of common shares outstanding
        during
        the period. Diluted net loss per share gives effect to all dilutive potential
        common shares
        outstanding during the period using the if-converted method. Diluted net
        loss
        per share excludes all potential dilutive common shares
        if
        their effect is anti-dilutive. The weighted average number of shares used
        to
        compute basic and diluted loss per share is the same since the effect of
        the
        dilutive securities is anti-dilutive.
 
 **Accounting
        for Stock-Based Compensation**
 
 Effective
        January 1, 2006, the Company adopted the fair value recognition provisions
        of Statement of Financial Accounting Standard ("SFAS") No. 123(R), using
        the
        modified prospective transition method. SFAS No. 123(R) requires all
        share-based payments to employees, including grants of employee stock options,
        to be recognized in the financial statements based on their fair values
        beginning with the first annual reporting period that begins after
        December 15, 2005, with early adoption encouraged.
 
 The
        Company implemented a Stock Incentive Plan (the “Incentive Plan”) in 2004 for
        which the Board of Directors has authorized 9,750,000 shares of common stock
        to
        be reserved for future issuance under the Plan. Stock options generally vest
        over three years and will expire 10 years from the effective date. However,
        the Company has the latitude under the Incentive Plan to issue options at
        various stages of vesting.
 
 Once
        these options are granted by the Board under the provisions of the plan,
        the
        Company will record a compensation charge for the difference between the
        fair
        value of the common stock and the exercise price of the options on the date
        of
        issuance if the fair value of the common stock exceeds the exercise price
        of the
        option on that date. The fair value of each option granted is estimated on
        the
        date of grant using the Black-Scholes option-pricing model. The assumptions
        used
        with this model for 2006 were an expected life of three years, a zero dividend
        yield, volatility ranging from 72% to 209% (depending on date of grant),
        and
        risk free interest rates ranging from 4.64% to 5.09% (depending on date of
        grant). The assumptions used with this model for 2005 were an expected life
        of
        3 years, a zero dividend yield, volatility ranging from 59% to 120%
        (depending on date of grant), and risk free interest rates ranging from 3.39%
        to
        3.96% (depending on date of grant). The estimated fair value of the options
        is
        amortized over the option’s vesting period.
 
 **Income
        Taxes**
 Income
        taxes are accounted for using the liability method in accordance with SFAS
        No. 109, “Accounting for Income Taxes.” Under SFAS 109, deferred tax assets
        or liabilities are computed based upon the difference between the financial
        statement and income tax bases of assets and liabilities using the enacted
        marginal tax rate applicable when the related asset or liability is expected
        to
        be realized or settled. Deferred income tax expense or benefits are based
        on the
        changes in the asset or liability from period to period. If available evidence
        suggests that it is more likely than not that some portion or all of a deferred
        tax asset will not be realized, a valuation allowance is recorded to reduce
        the
        deferred tax assets to the amount that is more likely than not to be realized.
        Future changes in such valuation allowance would be included in the provision
        for deferred income taxes in the period of change.
 
 **Use
        of Estimates**
 The
        preparation of financial statements in conformity with accounting principles
        generally accepted in the United States requires management to make estimates
        and assumptions that affect the reported amounts of assets and liabilities
        and
        disclosure of contingent assets and liabilities at the date of the financial
        statements and the reported amounts of revenues and expenses during the
        reporting periods. Actual results could differ from those
        estimates.
 
 **Foreign
        Subsidiaries**
 
 The
        Company has foreign subsidiaries whose local currency has been determined
        to be
        the functional currency. For these foreign subsidiaries, the assets and
        liabilities have been translated using the current exchange rates, and the
        income and expenses have been translated using the weighted average of
        historical exchange rates during the reporting period. The adjustments resulting
        from translation have been recorded separately in shareholders’
(deficit) equity as “other comprehensive income (loss)” and are not
        included in determining the consolidated net loss. As of March 31, 2007,
        accumulated other comprehensive loss included ($1,679) of cumulative losses
        from
        foreign currency translation.
 
 The
        Company began operations in Brazil in March of 2004 by establishing a 75%
        owned
        subsidiary. The Brazilian subsidiary recognized $0, $0 and $7,682 in revenue
        during the three months ended March 31, 2007 and 2006, and the period March,
        2004 (inception) through March 31, 2007, respectively, and had total assets
        less
        current liabilities (exclusive of intercompany amounts eliminated in
        consolidation) of $88,742 at March 31, 2007. Transactions in Brazil are
        denominated in, and the functional currency is, the Brazilian Real. Accordingly,
        no currency exchange rate gains or losses are recorded in the accompanying
        consolidated statement of operations for Brazilian operations. At March 31,
        2007, the Brazilian operations had aggregate losses of $1,703,596. The minority
        stockholder’s portion of aggregate losses is not recorded in the consolidated
        balance sheet since reimbursement of this amount from the minority stockholders
        is not assured.
 
 F-10
  O2Diesel
        Corporation
 (A
        Development Stage Company)
 Notes
        to
        Financial Statements
 
 The
        company began operations in Spain in April of 2006 by establishing a 100%
        subsidiary. The Spanish subsidiary did not recognize any revenue for the
        three
        months ended March 31, 2007 nor the period of April 2006 through March 31,
        2007.
        At March 31, 2007 the Spanish subsidiary had total assets less current
        liabilities (exclusive of intercompany amounts eliminated in consolidation)
        of
        $52,366. Transactions in Spain are denominated in and the functional currency
        is
        the Euro. At March 31, 2007, the Spanish operations had aggregate losses
        of
        $749,840.
 
 On
        December 31, 2004, the Company ceased operations at two of its wholly-owned
        subsidiaries in the United Kingdom. In connection with the cessation, the
        Company recorded an exchange gain in the 2004 consolidated statement of
        operations of $94,396 to recognize cumulative
        translation gains previously recorded in other comprehensive income (loss).
        The
        subsidiaries were primarily holding companies and had no assets or liabilities
        as of December 31, 2004. For the years ended December 31, 2005 and December
        31, 2006 and for the three months ended March 31, 2007, these subsidiaries
        incurred no activity and therefore had no profit or loss.
 
 **Segment
        Reporting**
 
 The
        Company is a development stage company and has not made sales of its products
        in
        commercial volumes. Management believes that the Company currently operates
        and
        manages the business as one business segment.
 
 **Impairment
        of Intellectual Property Rights**
 
 Prior
        to
        the fourth quarter of 2002, the Company was pursuing the marketability of
        a
        technology it had acquired for $424,659. In December, 2002, the Company
        determined that the related product was no longer commercially viable and
        would
        no longer be pursued. As a result of this decision, it was determined that
        the
        asset would not be recoverable as there was no alternative market for the
        technology. Accordingly, the net book value of $345,115 was charged to general
        and administrative expenses during 2002.
 
 **Interim
        Financial Statements**
 
 The
        unaudited interim consolidated financial statements of the Company have been
        prepared in accordance with accounting principles generally accepted in the
        United States for interim financial information. In the opinion of management,
        all adjustments (consisting of normal recurring adjustments) considered
        necessary to present fairly the financial position of the Company as of
        March 31, 2007 and the results of operations and cash flows presented
        herein for the three month periods ended March 31, 2007 and 2006 and from
        inception (October 14, 2000) through March 31, 2007 have been included
        in the financial statements. Interim results are not necessarily indicative
        of
        results of operations that may be expected for the year ending December 31,
        2007. It is recommended that this financial information be read with the
        complete financial statements included in the Company’s Form 10-KSB dated
        December 31, 2006 previously filed with the Securities and Exchange
        Commission.
 
 **3.
        Government Appropriations**
 
 **Appropriation
        from the U.S. Department of Energy (1)**
 
 In
        2002,
        the Company received an appropriation of $1,107,734 from the U.S. Department
        of
        Energy (“DOE”) to test the Company’s fuel additive as well as its blended fuel,
        O2DieselTM. The appropriation was increased to $2,039,651 as of
        September 15, 2004. This appropriation is managed for the DOE by the
        National Renewable Energy Laboratory (“NREL”) under a contract which, as
        amended, continues until June 30, 2007. Under the terms of the contract,
        the Company is reimbursed by NREL for 80% of the costs incurred to complete
        the
        Statement of Work as set forth in the contract. The Company charges all expenses
        as incurred to operations and accrues all amounts receivable under the contract
        as a reduction to contract expenses when the Company is reasonably certain
        all
        conditions of the reimbursement are satisfied. As of March 31, 2007, the
        Company had incurred cumulative costs of $2,013,647 towards completion of
        the
        contract, leaving a balance of $26,004 in costs to complete the contract.
        From
        the inception of the contract in December 2002 through March 31, 2007,
        the Company billed NREL $1,565,156 of which $16,317 is included in other
        receivables as of March 31, 2007. In addition, the Company recorded $45,761
        of unbilled receivables at March 31, 2007 under this
        appropriation.
  **Appropriation
        from the U.S. Department of Energy (2)**
 
 In
        2003,
        the Company received an appropriation of $1,123,834 to test the Company’s fuel
        additive under the CARB Diesel Emissions Control Strategy
        (DECS) verification rules. The Company is eligible to receive
        reimbursements of 80% of costs incurred under a contract up to the appropriation
        amount. This appropriation is managed for the DOE by NREL, the National
        Renewable Energy Laboratory. As of March 31, 2007, the Company had incurred
        cumulative costs of $575,175 towards completion of the contract, leaving
        a
        balance of $548,659 in costs to complete the contract. From the inception
        of the
        contract through March 31, 2007, the Company billed NREL $344,777 of which
        $33,847 is included in other receivables as of March 31, 2007. In addition
        the
        Company recorded $115,363 of unbilled receivables at March 31, 2007 under
        this
        appropriation.
  F-11
  O2Diesel
        Corporation
 (A
        Development Stage Company)
 Notes
        to
        Financial Statements
 
 **Appropriation
        from the U.S. Department of Energy (3)**
 
 During
        2004 and 2005, the Company has received $1,000,000 in available appropriations
        for the purpose of continued testing and
        verification of our fuel additive. The Company submitted a proposal to NREL
        and
        expects to have these funds under contract
        by the end of the second quarter 2007. These projects would be eligible for
        80%
        reimbursement.
 
 **Appropriation
        from the U.S. Department of Defense (1)**
 
 In
        2003,
        the Company received an appropriation of $1,000,000 from the U.S. Department
        of
        Defense to test O2DieselTM fuel in non-strategic military vehicles operated by
        the U.S. Air Force at Nellis Air Force Base in Las Vegas, Nevada. Under the
        terms of this Appropriation, a third party is to be paid $200,000 to administer
        this program on behalf of the Department of Defense. The remaining $800,000
        is
        to be used to fund purchases of O2DieselTM fuel, certain capital equipment and to
        reimburse the Company for its labor, overhead and out-of-pocket costs required
        to complete this project. Under this program, the Company is required to
        meet
        certain milestones as a condition to receiving reimbursements for its costs.
        Thus, upon achieving a milestone, the Company accrues the amount due and
        submits
        an invoice for reimbursement. All amounts are expensed as incurred, and all
        amounts receivable for work completed are treated as a reduction to expense
        over
        the period earned. The period of performance for this program ran from
        October 7, 2003 to December 31, 2004. Through December 31, 2004,
        the Company had achieved five milestones and, since inception, has billed
        $360,000 related to this appropriation, of which $160,000 was billed in January,
        2005. By its terms, this contract expired on December 31, 2004 and will not
        be extended. No activity under this appropriation has taken place subsequent
        to
        March 31, 2005. The work
        required to achieve the milestones not completed as of December 31, 2004,
        has been included as part of the Statement of Work for Appropriation
        (2) from the U.S. Department of Defense as is permitted under that
        contract. However, the funds from Appropriation (1) cannot be applied to
        Appropriation (2). Through December 31, 2005, the Company has received cash
        in excess of costs incurred of $296,097 and has recorded Deferred Grants
        at
        December 31, 2005 in the Consolidated Balance Sheet. All amounts billed had
        been received as of December 31, 2005. No additional reimbursements are
        expected from this appropriation. During the fourth quarter of 2006 the Company
        was notified from the subcontractor that the contract was officially closed
        and
        O2Diesel has no further requirements. Based on this information, the Company
        applied the previously recorded liability of $296,097 for this contract as
        an
        offset to 2006 grant expenses for the year ended December 31, 2006.
 
 **Appropriation
        from the U.S. Department of Defense (2)**
 
 On
        January 11, 2005, the Company entered into a contract with a value of
        $1,085,000 with the U.S. Department of Defense. Under this
        contract, the Company's O2DieselTM fuel is to be tested in a maximum of forty
        (40) non-tactical vehicles at US Air Force bases in
        Nevada
        for an 18 month period. Furthermore, the Company is to complete certain
        engine testing and other work required for the acceptance
        of O2DieselTM
        as a viable alternative fuel for use by the Air Force. Work on this contract
        commenced on November 1, 2004
        and
        is to continue through November 30, 2006. Notwithstanding that the
        agreement for this contract was signed in January 2005, the
        Company was asked to begin work in 2004 and, by a letter from Innovative
        Technologies Corporation (ITC), was authorized to incur
        costs in an amount not to exceed $75,000. This is a time and materials contract
        that is administered for the U.S. Department of
        Defense by a third party contractor. The Company charges all costs as incurred
        to expense and accrues all amounts receivable under the
        contract as a reduction to contract expenses. The contract amount was amended
        in
        May 2006 to $1,012,564. The amount of the reduction
        will be added to a future contract through the Air Force. Billings under
        this
        contract are made monthly. As of December 31,
        2006,
        costs totaling $1,011,215 had been incurred, billed, and received. As of
        March
        31, 2007, there is a balance of $1,349 in the
        contract, but no further activity is expected. The contract will be officially
        closed out during 2007.
 
 **Appropriation
        from the U.S. Department of Defense (3)**
 
 The
        Company received an appropriation during 2005 of approximately $910,000 from
        the
        Department of Defense. Concurrent Technologies Corporation (CTC) manages
        this appropriation on behalf of the Department of Defense. This contract
        contains a payment schedule based on meeting performance milestones. Five
        milestones were achieved by March 31, 2007. The primary objective of this
        contract is to create potential fuels using the Company additive that contain
        no
        more than 80% petroleum. If this project is successful, an application will
        be
        made to EPA for alternative fuel status, creating an incentive for federal
        customers to use the fuel. Part of this research entails conducting
        demonstrations in various climates at three Air Force bases, including Nellis
        Air Force Base (expanded fleet) in Nevada. As of March 31, 2007 the Company
        has
        recorded expenses of $631,536 against this contract, leaving a balance of
        $278,464. The Company invoiced $555,000 for the five milestones on this project
        through March 31, 2007, of which $25,000 was recorded as a receivable as
        of
        March 31, 2007. The Company also recorded $76,536 as an unbilled receivable
        under this appropriation as of March 31, 2007.
 
 **Appropriation
        from the U.S. Department of Defense (4)**
 
 In
        2005,
        the Company received an appropriation of approximately $1,100,000 for expanded
        testing and verification of O2DieselTM. As
        of
        March 31, 2007 the Company has received a letter contract for $175,000 which
        authorizes the Company to begin work
        and
        incur costs. This also enabled us to issue a milestone invoice of $112,950
        which
        is recorded as a receivable as of
        March
        31, 2007. This letter contract will be amended during the second quarter
        of 2007
        to increase the amount to $575,000. As
        of
        March 31, 2007, the Company had incurred no costs against this appropriation
        and
        therefore recorded $112,950 as a deferred grant
        on
        the balance sheet at March 31, 2007.
 
 F-12
 
 O2Diesel
        Corporation
 (A
        Development Stage Company)
 Notes
        to
        Financial Statements
  **Appropriation
        from the U.S. Department of Defense (5)**
 
 In
        2006,
        the Company received an appropriation of approximately $1,000,000 for continued
        testing and verification of O2Diesel TM.
        The
        Company expects to enter into a contract for this work during the second
        quarter
        of 2007. The Company can receive reimbursement from this appropriation of
        up to
        the entire $1,000,000
 
 **4.
        Other Receivables**
  March
                  31, 2007Other
                  ReceivablesDue
                  from ProEco
              
              $
              400,000CTC
                  Appropriation
              
              
              137,950NREL
                  Appropriation
              
              
              50,164Reimbursement
                  of expenses and services performed
              
              
              22,457$
              610,571
 
 **5.
        Accrued Expenses**
  March
                  31, 2007Accrued
                  LiabilitiesLegal
                  and professional
              
              $
              77,829Other
              
              
              207,925$
              285,754
 
 **6.
        Deferred Financing and Business Acquisition Costs**
 
 During
        2003, management began the public listing process on the Alternative Investment
        Market (AIM) in London, England. All legal, accounting, and other related
        costs
        incurred in connection with the AIM listing were capitalized as deferred
        financing costs. In December 2003, management determined that the Company
        would terminate its plan to seek an AIM listing. Accordingly, deferred financing
        costs of $517,000, were charged to expense for the year ended December 31,
        2003.
 
 The
        Company records the cost of equity financings as a reduction of the associated
        proceeds.
 
 **7.
        Income Taxes**
 
 No
        provision for Federal and state income taxes has been recorded during the
        periods presented due to the Company’s significant operating losses. The income
        tax benefit reflected in the accompanying consolidated statement of operations
        is the current benefit recognized in Ireland for the periods
        presented.
 
 Deferred
        income taxes reflect the net tax effects of temporary differences between
        the
        carrying amounts of assets and liabilities for financial reporting purposes
        and
        the amounts used for income tax reporting purposes. Significant components
        of
        the Company’s deferred tax asset as of March 31, 2007:
  March
                  31, 2007Income
                  taxesNet
                  operating loss carryforwards
              
              $
              10,240,000Deferred
                  revenue
              
              
              54,000Accrued
                  expenses
              
              
              125,000Total
                  deferred tax assets
              
              
              10,419,000Valuation
                  allowance
              
              
              (10,419,000
              )Net
                  deferred tax assets
              
              $
              —
 
 F-13
 
 O2Diesel
        Corporation
 (A
        Development Stage Company)
 Notes
        to
        Financial Statements
 
 Management
        has determined that a valuation allowance equal to 100% of the existing deferred
        tax assets is appropriate given the uncertainty regarding the ultimate
        realization of these assets. At March 31, 2007, the Company had Federal and
        state net operating loss carryforwards of approximately $24.0 million for
        income tax purposes. If not used, these carryforwards expire through 2021
        for
        Federal and state tax purposes. Federal tax rules impose limitations on the
        use
        of net operating losses following certain changes in ownership.
        If such a change occurs, the limitation would reduce the amount of the benefits
        that would be available to offset future taxable income each year, starting
        with
        the year of ownership change. As of March 31, 2007, the Company had an
        Irish net operating loss carryforward of approximately $640,000 which can
        be
        carried forward indefinitely, cumulative Spanish losses of approximately
        $725,000 and a Brazilian net operating loss of approximately $1,450,000 that
        may
        be carried forward indefinitely, but which is subject to annual usage
        limitations.
 In
          July
          2006, The Financial Accounting Standards Board ("FASB") issued FASB
          Interpretation No. 48, “Accounting for Uncertainty in Income Taxes- an
          interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the
          accounting and disclosure for uncertainty in tax positions, as defined
          and
          prescribes the measurement process and a minimum recognition threshold,
          for a
          tax position taken or expected to be taken in a tax return, that is required
          to
          be met before being recognized in the financial statements. Under FIN 48,
          the
          Company must recognize the tax benefit from an uncertain tax position only
          if it
          is more likely than not that the tax position will be sustained on examination
          by the taxing authorities, based on the technical merits of the position.
          The
          tax benefits recognized in the financial statements from such a position
          are
          measured based on the largest benefit that has a greater than 50% likelihood
          of
          being realized upon ultimate resolution.
 
 The
          Company is subject to the provisions of FIN 48 as of January 1, 2007, and
          has
          analyzed filing positions in all of the U.S. federal and state jurisdictions
          where it is required to file income tax returns, its federal and state tax
          returns in Ireland, Spain and Brazil and all open tax years in these
          jurisdictions. The Company has identified its U.S. federal tax return and
          its
          state tax returns in Delaware and California as “major” tax jurisdictions as
          defined. Based on the Company’s evaluation, we have concluded that there are no
          significant uncertain tax positions requiring recognition in our financial
          statements. Our evaluation was performed for the tax years which remain
          subject
          to examination by the major U.S. tax jurisdictions (tax years ended December
          31,
          2003 to December 31, 2006) and for the tax years which remain open for
          examination in Ireland (December 31, 2006), Spain (December 31, 2006) and
          Brazil
          (December 31, 2006). Based on this evaluation, no reserves for uncertain
          income
          tax positions have been recorded pursuant to FIN 48 during the period ended
          March 31, 2007 and the Company does not anticipate that it is reasonably
          possible that any material increase or decrease in its unrecognized tax
          benefits
          will occur within twelve months. In addition, the Company did not record
          a
          cumulative effect adjustment related to the adoption of FIN 48.
 
 Upon
          adoption on January 1, 2007 and as of March 31, 2007, the Company had no
          unrecognized tax benefits or accruals for the potential payment of interest
          and
          penalties. The Company’s policy for recording interest and penalties associated
          with tax audits is to record such items as a component of income or loss
          before
          provision (benefit) for income taxes. Penalties are recorded in other expenses
          and interest paid or received is recorded in interest expense or interest
          income
          related to the settlement of tax audits for certain prior periods. For
          the
          period ended March 31, 2007, there were no interest or penalties recorded
          relating to the settlement of tax audits.


**8.
        Stockholders’ Equity**
 
 **Recapitalization**
 
 On
        July 15, 2003, O2Diesel Corporation and AAE Technologies International Plc
        (AAE) entered into a merger transaction whereby O2Diesel acquired all of
        the issued and outstanding share capital of AAE in exchange for the issuance
        of
        17,847,039 shares of common stock of O2Diesel. Although O2Diesel was the
        legal
        acquirer, AAE was deemed to be the accounting acquirer. The transaction was
        accounted for as an AAE capital transaction, accompanied by a
        recapitalization.
 
 As
        a
        result of the transaction, the historical financial statements of AAE are
        deemed
        to be those of the Company for financial reporting purposes. The equity accounts
        of AAE have been adjusted for the recapitalization to reflect the equity
        structure of O2Diesel, the legal acquirer. Specifically, the historical
        stockholders’ equity of AAE prior to the transaction has been affected for the
        equivalent number of shares of O2Diesel common stock received in the
        transaction, with an offset to paid-in capital; the accumulated deficit of
        AAE
        was carried forward after the transaction; and the loss per share for all
        periods prior to the transaction was restated to reflect the number of
        equivalent common shares received by AAE in the transaction.
 
 **Issuances
        of Common Stock**
 
 In
        connection with the merger between O2Diesel and AAE in July 2003, the
        Company completed a private placement of 3,333,333 shares of common stock
        at
        $1.50 per share. The private placement was partially effectuated through
        the
        issuance of a $4 million convertible note that was convertible into the
        Company’s common stock at $1.50 per share. In October 2003, the Company
        repaid $1,677,500 of the note and the $2,322,500 balance was converted into
        1,548,333 shares of common stock. The remaining 1,785,000 shares of common
        stock
        issuable under the private placement were issued to other parties in exchange
        for cash proceeds of $2,677,500. The expenses associated with the merger
        and
        subsequent issuances of shares were $795,650 and have been reflected as a
        reduction of paid-in capital.
 
 Subsequent
        to its first private placement in 2003, the Company undertook to raise an
        additional $3.5 million through a follow-on private placement of our common
        stock (the “Follow-On Private Placement”). In the Follow-On Private Placement,
        we raised $1,535,770, before expenses, and issued 1,025,784 shares of our
        common
        stock at a price of $1.50 per share. The Follow-On Private Placement was
        closed
        on March 31, 2004. There was no underwriter involved in the Follow-On
        Private Placement. Sales of common stock under the Follow-On Private Placement
        that were completed in non-U.S. transactions were exempt from registration
        pursuant to Regulation S promulgated under the Securities Act of 1933, as
        amended (the “Securities Act”). The sales of common stock under the Follow-On
        Private Placement to accredited U.S. investors were exempt pursuant to
        Regulation D promulgated under the Securities Act.
  F-14
 
 O2Diesel
        Corporation
 (A
        Development Stage Company)
 Notes
        to
        Financial Statements
 **$2.0
        and $3.0 Million Private Placements**
 
 In
        a
        series of two private placements of the Company's common stock in 2005, the
        Company raised $4,833,192 after payment of an 8% commission and other expenses,
        and issued 7,535,981 shares of common stock at a price of $0.70 per share.
        Subscribers to these private placements received for each two shares of common
        stock purchased one warrant to purchase one additional share of common stock.
        The warrant expires twenty-four months following the closing of the private
        placement. Each warrant is exercisable at a price of $0.70 per share during
        the
        first twelve months following the close of the private placement, or at an
        exercise price of $1.05 per share in the second twelve months following the
        close the private placement. The total number of warrants issued was 3,757,990.
        The common stock and the warrants were issued to the accredited investors
        in a
        transaction that will be exempt from registration pursuant to Section 4(2)
        of
        the Securities Act, and/or Regulation D promulgated under the Securities
        Act.
 
 **$2.3
        Million Private Placement**
 
 On
        October 24, 2005, the Company issued 3,228,070 shares of common stock at
        a
        purchase price of $0.7125 per share in a private placement for total proceeds
        of
        $2,300,000.
  As
        part
        of this sale, the Company also issued warrants to purchase 1,614,035 shares
        of
        common stock at an exercise price of $1.425 per share during the period of
        six
        months to forty-two months subsequent to issuance or at a cashless exercise
        if a
        registration statement is not effective within one year of issuance. The
        warrants expire forty-two months after the date of issuance.
 
 As
        part
        of the transaction, the Company agreed to sell up to an additional $700,000
        of
        its common stock to the Purchaser at a purchase price of $0.7125 per share
        for
        982,456 shares. The Company also issued warrants to purchase 491,228 shares
        of
        common stock at an exercise price of $1.425 per share during the period of
        six
        months to forty-two months subsequent to issuance or at a cashless exercise
        if a
        registration statement is not effective within one year of issuance. The
        warrants expire forty-two months after the date of issuance. The purchaser
        had
        180 days following the date of the Purchase Agreement to acquire additional
        shares. This offer expired unexercised on March 20, 2006.
 
 The
        Company agreed to issue warrants to purchase 1,614,035 shares of common stock
        at
        an exercise price of $0.7125 per share to its advisor in connection with
        this
        transaction. The warrants expire forty-two months after the date of issuance.
        The common stock and the warrants were issued to the accredited investor
        in a
        transaction that will be exempt from registration pursuant to Section 4(2)
        of
        the Securities Act, and/or Regulation D promulgated under the Securities
        Act.
 
 **$3.6
        Million Private Placement**
 
 On
        December 16, 2005, the Company issued 6,419,840 shares of the Company's common
        stock in a private placement, for total proceeds of 3,000,000€, or approximately
        $3.6 million at the then current exchange rates.
 
 As
        part
        of the transaction, the Company issued warrants to purchase 2,853,262 shares
        of
        common stock at an exercise price of $0.85 per share during the period six
        to
        forty two months subsequent to the date of issuance or at an exercise price
        of
        $1.13 per share during the period forty three to sixty six months after the
        date
        of issuance. The warrants expire sixty six months after the date of
        issuance.
 
 **$4.0
        and $2.5 Million Private Placements**
  On
        April
        6, 2006, the Company entered into a Common Stock and Warrant Purchase Agreement
        (“$4.0 Million Purchase Agreement”) with a UK investor (the “Investor”) for
        5,333,333 shares of common stock at a purchase price of $0.75 per share in
        a
        private placement for total proceeds of $4,000,000 (the “$4.0 Million Private
        Placement”). As part of this sale, the Company also issued warrants to purchase
        2,666,667 shares of common stock at an exercise price of $0.825 per share
        during
        the period of six months to forty-two months subsequent to issuance. The
        warrants expire forty-two months after the date of issuance. The Investor's
        obligation to purchase the shares was subject to the Company satisfying certain
        additional conditions.
 
 Also
        on
        April 6, 2006, the Company entered into a Common Stock and Warrant Purchase
        Agreement (“$2.5 Million Purchase Agreement”) with a different European
        investor (the “2 nd Investor”) for 3,333,333 shares of common stock at a purchase price of $0.75 per
        share in a private placement for total proceeds of $2,500,000 (the “$2.5 Million
        Private Placement”) before payment of a 9% commission and other expenses. As
        part of this sale, the Company also issued warrants to purchase 1,666,667
        shares
        of common stock at an exercise price of $0.825 per share during the period
        of
        six months to forty-two months subsequent to issuance. The warrants expire
        forty-two months after the date of issuance. The 2 nd Investor's obligation to purchase the shares was subject to the Company
        satisfying certain additional conditions.
 
 Subsequent
        to entering into these agreements, the Company entered into an identical
        amendment to each agreement which (i) modified the amount of liquidated damages
        to a maximum of 8% of the purchase price and (ii) added that shareholder
        approval will be obtained prior to the Company issuing the shares of common
        stock issuable upon exercise of the warrants. There were no other changes
        to
        either agreement. Both transactions closed and the warrants were issued on
        April
        27, 2006.
 
 F-15
  O2Diesel
        Corporation
 (A
        Development Stage Company)
 Notes
        to
        Financial Statements
 
 
 AMEX
        requires that shareholder approval be obtained by the Company for the sale
        of
        common stock in a transaction if the price of the shares to be sold is less
        than
        the greater of book or market value, and the number of shares is equal
        twenty-percent (20%) or more of the presently outstanding common stock. In
        order
        to comply with this requirement, the Company was required to obtain shareholder
        approval for the $4.0 and the $2.5 million Private Placements. Shareholder
        approval was obtained at the Company's annual shareholder meeting on July
        6,
        2006.
 
 **$1.0
        Million Private Placement**
 
 On
        November 9, 2006, the Company issued 1,371,742 shares of the Company's common
        stock at a purchase price of $0.729 per share in a private placement for
        total
        proceeds of $1,000,000.
 
 As
        part
        of the sale, the Company issued warrants to purchase 685,871 shares of common
        stock at an exercise price of $0.972 per share during the period of six months
        to sixty-six months subsequent to issuance. The warrants expire
        sixty-six months after the date of issuance. The investor's obligation to
        purchase the shares is subject to the Company satisfying certain additional
        conditions.
 
 The
        common stock and the warrants were issued to the accredited investor in a
        transaction that is exempt from registration pursuant to Section 4(2) of
        the Securities Act, and/or Regulation D promulgated under the Securities
        Act.
 
 The
        transaction closed and the funds were received on November 22,
        2006.
 
 **$10.0
        Million Private Placement**
 
 On
        February 16, 2007, the Company entered into a common stock purchase agreement
        (the “Purchase Agreement”) with Fusion Capital Fund II, LLC, an Illinois limited
        liability company (“Fusion Capital”). Pursuant to the Purchase Agreement, at the
        Company's discretion, the Company may sell up to $10 million of the Company's
        common stock to Fusion Capital from time to time over a 25-month period.
        The
        Company has reserved for issuance up to 12,000,000 shares of the Company's
        common stock for sale to Fusion Capital under this agreement. Subject to
        earlier
        termination at the Company's discretion, Fusion Capital's purchases will
        occur
        after the SEC has declared effective the registration statement related to
        the
        transaction. The Company has issued to Fusion Capital 805,987 shares of the
        Company's common stock as a commitment fee for entering into the Purchase
        Agreement.
 
 Concurrently
        with entering into the Purchase Agreement, the Company entered into a
        registration rights agreement with Fusion Capital (the “Registration Rights
        Agreement”). Under the Registration Rights Agreement, the Company agreed to file
        a registration statement with the SEC covering the shares that have been
        issued
        or may be issued to Fusion Capital under the Purchase Agreement. After the
        SEC
        has declared effective the registration statement, generally the Company
        has the
        right but not the obligation from time to time to sell shares of the Company's
        common stock to Fusion Capital in amounts between $100,000 and $1 million
        depending on certain conditions. The Company has the right to control the
        timing
        and amount of any sales of the Company's shares to Fusion Capital. The purchase
        price of the shares will be determined based upon the market price of the
        shares
        of common stock without any fixed discount. Fusion Capital shall not have
        the
        right or the obligation to purchase any shares of the Company's common stock
        on
        any business day that the price of the Company's common stock is below either
        $0.50 or $0.60, depending on the transaction size of the purchase. The agreement
        may be terminated by the Company at any time at its discretion without any
        cost
        to the Company.
 
 **Issuances
        of Preferred Stock**
 
 **Series A
        0% Convertible Preferred Stock Private Placement**
  Pursuant
        to a Convertible Preferred Stock Purchase Agreement between the Company and
        the
        purchaser named therein (the “Series A Purchaser”) dated as of
        March 3, 2004, the Company issued to the Series A Purchaser, 800,000
        shares of Series A 0% Convertible Preferred Stock, par value $.0001
        (“Series A Preferred Stock”). The offering resulted in gross proceeds of
        approximately $3,200,000 to the Company, prior to the deduction of fees and
        commissions. The sale of the Series A Preferred Stock was exempt
        from registration
        pursuant to Regulation S promulgated under the Securities Act. The
        Series A Preferred Stock was initially convertible into the Company's
        common stock at a variable conversion ratio which was the lesser of (a) $4.00
        as
        adjusted as provided in the Series A Certificate of Designation (the
“Series A Fixed Conversion Price”) or (b) eighty percent (80%) of the
        lowest closing bid price for the Common Stock in the ten business days preceding
        the date of conversion, but, in no case, less than 50% of the Series A
        Fixed Conversion Price. In September 2004, we renegotiated the conversion
        formula with the holder of these shares. Now the minimum price at which the
        shares may be converted is equal to twenty-five percent (25.0%) of the Fixed
        Conversion Price, or $1.00 per share. Pursuant to the amended agreement,
        the
        Series A Purchaser may not convert Series A Preferred Stock into our
        common stock for a period of two (2) years following the closing date of
        this transaction. Under the revised agreement, in no event will the
        Series A Purchaser receive more than 8,000,000 or less than 2,000,000
        shares of the Company's common stock upon conversion of the Series A
        Preferred Stock.
  F-16
  O2Diesel
        Corporation
 (A
        Development Stage Company)
 Notes
        to
        Financial Statements
 
 
 The
        Series A Purchaser was granted an option to purchase additional shares of
        the Company's common stock equal to the difference between the number of
        shares
        of common stock actually received upon conversion and the number of shares
        that
        would have been received at a conversion price of $1.82. The exercise price
        shall be the Series A Fixed Conversion Price.
 
 **Series B
        0% Convertible Preferred Stock Private Placement**
  Pursuant
        to a Convertible Preferred Stock Purchase Agreement between the Company and
        the
        purchaser named therein (the “Series B Purchaser”) dated as of
        March 29, 2004, the Company issued to the Series B Purchaser, 750,000
        shares of Series B 0% Convertible Preferred Stock, par value $.0001
        (“Series B Preferred Stock”). The offering resulted in gross proceeds
        of approximately $3,000,000 to the Company, prior to the deduction of fees
        and
        commissions. The sale of the Series B Preferred Stock was exempt from
        registration pursuant to Regulation S promulgated under the Securities
        Act.
  The
        Series B Preferred Stock was initially convertible into the Company's
        common stock at a variable conversion ratio which was the lesser of (a) $3.65
        as
        adjusted as provided in the Series B Certificate of Designation (the
“Series B Fixed Conversion Price”) or (b) eighty percent (80%) of the
        lowest closing bid price for the Common Stock in the ten business days preceding
        the date of conversion, but, in no case, less than 50% of the Series B
        Fixed Conversion Price. In September 2004, we renegotiated the conversion
        formula with the holder of these shares. Now the minimum price at which the
        shares may be converted is equal to twenty-seven and four tenths per cent
        (27.4%) of the Series B Fixed Conversion Price, or $1.00 per share.
        Pursuant to the amended agreement, the Series B Purchaser may not convert
        Series B Preferred Stock into our common stock for a period of two
        (2) years following the closing date of this transaction. Under the revised
        agreement, in no event will the Series B Purchaser receive more than
        7,500,000 or less than 2,054,795 shares of the Company's common stock upon
        conversion of the Series B Preferred Stock.
  The
        Series B Purchaser was granted an option to purchase additional shares of
        the Company's common stock equal to the difference between the number of
        shares
        of common stock actually received upon conversion and the number of shares
        that
        would have been received at a conversion price of $1.82. The exercise price
        shall be the Series B Fixed Conversion Price.
 
 In
        April
        2006, the holders of both the Series A and Series B Convertible Preferred
        Stock
        exercised all of their conversion rights and converted 1,550,000 shares of
        Convertible Preferred Stock into 15,500,000 shares of common stock.
 
 **Warrants**
 
 A
        wholly-owned subsidiary of the Company entered into a supply and distribution
        agreement (the “Distribution Agreement”) with a distributor dated July 10,
        2001 that granted the distributor the right to purchase up to 10% of the
        outstanding common stock of the Company for $1.00 per share should certain
        sales
        targets be achieved. The warrant was to expire on July 10, 2006. None of
        the sales targets have been achieved under the Distribution Agreement and
        as of
        December 10, 2004 this Distribution Agreement was terminated and replaced
        by a new supply and distribution agreement (the “New Agreement”). Under this New
        Agreement, the distributor received a warrant to purchase 600,000 shares
        of
        O2Diesel’s common stock at a price of $2.00 per share, which expired on
        May 5, 2007.
 
 On
        February 3, 2006, the Company offered existing warrant holders from the
        $2.0 million and $3.0 million Private Placements and the $2.3 million
        Private Placement an opportunity to exercise their warrants at the reduced
        price
        of $0.35 per share. On February 27, 2006, the Warrant Offering expired and
        the Company received proceeds of $592,692 (after expenses) for the exercise
        of
        warrants to purchase 1,864,035 shares of common stock. Between May 31-June
        12,
        2006, several other existing warrant holders elected to exercise their warrants
        at the contract price identified in their warrant documentation. Proceeds
        for
        these exercises were $865,452 (after expenses) for the purchase of 1,287,857
        shares of common stock.
 
 On
        April
        27, 2007, the Company offered existing warrant holders an opportunity to
        exercise their warrants at the reduced price of $0.50 per share. The warrant
        offer will expire on May 25, 2007. If all eligible warrant holders were to
        exercise their warrants at the reduced price, the Company would receive proceeds
        of approximately $4.3 million. On May 9, 2007, the Company extended this
        reduced
        price offer until June 8, 2007. As of May 15, 2007, the Company amended the
        offer to grant the warrant holders, who tender their warrants, additional
        shares
        of Common Stock if the Company enters into any agreement for the sale of
        shares of Common Stock at less than $0.50 per share prior to June 8,
        2008. As of May 15, 2007, the Company had not determined the number of
        warrant holders intending to exercise this reduced price offer.
 
 F-17
 
 O2Diesel
        Corporation
 (A
        Development Stage Company)
 Notes
        to
        Financial Statements
 
 **Options**
 
 The
        Company implemented a Stock Incentive Plan (the “Incentive Plan”) in 2004 for
        which the Board of Directors has authorized 9,750,000 shares of common stock
        to
        be reserved for future issuance under the Incentive Plan.
 
 The
        following table shows the outstanding options granted under the 2004 Stock
        Incentive Plan:
 
 **Weighted
                  Ave****Remaining****Weighted
                  Ave**
              
              **Contractual****Shares**
              
              **Exercise
                  Price**
              
              **Term**Outstanding
                  at January 1, 2004
              
              
              500,000
              
              $
              1.50Granted
                  in 2005
              
              
              5,450,000
              
              $
              1.50
              
              
              8.4Exercised
                  in 2005Forfeited
                  or ExpiredOutstanding
                  at December 31, 2005
              
              
              5,950,000
              
              $
              1.50
              
              
              8.4Granted
                  During the Year Ended December 31, 2006
              
              
              1,350,000
              
              $
              1.28
              
              
              9.3200,000
              
              $
              1.50
              
              
              9.3100,000
              
              $
              0.71
              
              
              9.7Exercised
                  During the Year Ended December 31, 2006Forfeited
                  or Expired
              
              
              (100,000
              )
              $
              1.28Outstanding
                  at December 31, 2006
              
              
              7,500,000
              
              $
              1.45
              
              
              8.6Granted
                  During the Three Months Ended March 31, 2007
              
              
              -
              
              
              -
              
              
              -Exercised
                  During the Three Months Ended March 31, 2007
              
              
              -
              
              
              -
              
              
              -Forfeited
                  or Expired
              
              
              -
              
              
              -
              
              
              -Outstanding
                  at March 31, 2007
              
              
              7,500,000
              
              $
              1.45
              
              
              8.6Exercisable
                  at March 31, 2007
              
              
              5,783,000
              
              $
              1.47
              
              
              8.6
 
 **Restricted
        Stock Awards**
 
 On
        November 16, 2006, the Board of Directors approved the grant of 500,000 shares
        of restricted stock to Mr. Roger, pursuant to the terms of the Company's
        2004
        Stock Incentive Plan and Mr. Roger's employment agreement. The terms of the
        award were that the shares were to be issued on January 1, 2007 with 166,667
        shares to vest on January 1, 2007, 166,667 shares to vest on January 1, 2008
        and
        166,666 shares to vest on January 1, 2009. The receipt of shares is contingent
        on Mr. Roger remaining employed by the Company on the date of vesting. In
        2006,
        there was no FAS 123(R) expense for the grant of restricted stock.
 
 The
        following schedule presents shares of common stock issued and outstanding
        and
        reserved for future issuance as of March 31, 2007:
 
 **O2Diesel Corporation
                  - Common Shares Outstanding and Reserved for Future
                  Issuance**Common
                  Shares Outstanding
              
              
              
              
              
              75,342,343Reserved
                  For Future IssuanceOptions
                  Granted to officers and directors
              
              
              7,500,000Unearned
                  common stock issued for compensation
              
              
              333,333Unearned
                  common stock issued for commitment shares
              
              
              755,325Warrants
              
              
              11,527,564
              
              
              20,116,222Total
                  shares issued and outstanding and reserved for future issuance
                  as of March
                  31, 2007
              
              
              
              
              
              95,458,565
 
 F-18
 
 O2Diesel
        Corporation
 (A
        Development Stage Company)
 Notes
        to
        Financial Statements
 
 **9. Related
        Party Transactions**
 
 A
        company
        controlled by the former Chairman of the Board provides office space, accounting
        and other services to the Company at a cost of approximately $2,500 per month.
        The Company paid $16,509 of which approximately $5,500 related to the first
        three months of 2007, and accrued $2,500 for the three months ended
        March 31, 2007 and paid $0, and $196,360 respectively for the three months
        ended March 31, 2006 and for the period October 14, 2000
        (inception) through March 31, 2007, to the company controlled by the
        former Chairman.
 
 Included
        in receivables due from related parties at March 31, 2007 is $36,173 which
        is related to travel advances made to employees.
 
 The
        Company has entered into two separate consulting contracts with two shareholders
        of its Brazilian subsidiary for the purpose of providing office rent and
        administrative services and in lieu of employment contracts with these two
        individuals. These two contracts provide support significant to the operation
        of
        the Brazilian subsidiary. For the three months ended March 31, 2007,
        March 31, 2006 and the period October 14, 2000
        (inception) through March 31, 2007 the Company incurred expenses from
        these contracts of $34,342, $57,101 and $507,734, respectively.
 
 **10.
        Commitments**
 
 **Operating
        leases**
 
 The
        Company leases office space and certain office equipment under agreements
        that
        are accounted for as operating leases. As of March 31, 2007, future minimum
        lease payments under non-cancelable operating leases expiring through 2008,
        were
        as follows:
 
 Operating
        Leases
 2007
              
              $
              76,1442008
              
              
              89,779Total
              
              $
              165,923
 
 Rent
        expense under the leases with unrelated parties was $39,196 for the three
        months
        ended March 31, 2007 and was $26,299 and $335,671 for the three months
        ended March 31, 2006 and for the period October 14, 2000
        (inception) through March 31, 2007.
 
 F-19
 
 **** O2Diesel
        Corporation
 (A
        Development Stage Company)
 March 31,
        2007
 
 **ITEM
        2. MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF
        OPERATION**
 
 **OVERVIEW**
 
 **Business
        Plan**
 
 The
        Company is classified as a development stage company as shown on its unaudited
        consolidated financial statements for the period from inception
        (October 14, 2000) through March 31, 2007.
 
 O2Diesel’s
        predecessor, Dynamic Ventures, Inc., was incorporated in the State of Washington
        on April 24, 2000. Dynamic Ventures, Inc. changed its name to O2Diesel
        Corporation effective June 10, 2003, in contemplation of the reverse
        acquisition of AAE Technologies International Plc (“AAE”). On July 15,
        2003, O2Diesel acquired all of the issued and outstanding share capital of
        AAE
        in exchange for 17,847,039 shares of its common stock (the “Offer”). As a result
        of this transaction, the former shareholders of AAE acquired control of the
        combined companies. The acquisition of AAE has been accounted for as a capital
        transaction followed by a recapitalization as AAE was considered to be the
        accounting acquirer. Accordingly, the historical consolidated financial
        statements of AAE are considered to be those of O2Diesel for all periods
        presented.
 
 In
        conjunction with the reverse acquisition, the Company completed a private
        placement of its common stock whereby it issued 3,333,333 shares of common
        stock
        at $1.50 per share. Of the $5.0 million raised, approximately $800,000 was
        used
        to pay the costs of the reverse acquisition and private placement,
        $1.0 million was used to repay a bridge loan that was made in contemplation
        of the transaction, and the balance of $3.2 million was used to fund the
        ongoing developmental activities of the Company.
 
 Subsequent
        to the Offer and during 2003, the Company undertook an effort to raise an
        additional $3.5 million through a follow-on private placement. Pursuant to
        the follow-on financing, the Company issued 1,025,784 shares of its common
        stock
        at $1.50 per share for total proceeds of $1,535,877. The follow-on placement
        was
        closed as of March 31, 2004.
 
 On
        December 29, 2004, the Company consummated a merger (the “Reincorporation
        Merger”) with and into its wholly owned subsidiary, O2Diesel Delaware
        Corporation, a Delaware corporation (“O2Diesel Delaware”), in order to
        reincorporate in the State of Delaware (the “Reincorporation”). The
        Reincorporation Merger was affected pursuant to an Agreement and Plan of
        Merger
        entered into between the Company and O2Diesel Delaware on December 29,
        2004. The Reincorporation was submitted to a vote of, and approved by, the
        Company's shareholders at its annual meeting held on August 16, 2004. As a
        result of the Reincorporation, the legal domicile of the Company is now
        Delaware. The merger became effective on December 31, 2004.
 
 Since
        July 2003, the Company has raised approximately $33 million for its
        operations.
 
 **Transactions
        During the First Quarter of 2007**
  **ProEco
        Transaction**
  On
        January 12, 2007, the Company entered into a share exchange agreement (the
        “Share Exchange Agreement”) with ProEco Energy Company, Inc. (“ProEco”) and its
        shareholders (“ProEco Shareholders”) to acquire shares equal to 80% of the
        outstanding capital stock of ProEco in exchange for approximately 9.2 million
        shares of the Company’s common stock (the “Transaction Shares”) valued at $0.872
        per share for a total purchase price of $8.0 million.
  ProEco,
        which has had limited operations to date, is in the process of developing a
        new fuel-grade ethanol plant (the “Ethanol Plant”) with planned capacity of 100
        million gallons per year to be built in two 50 million gallon trains (each
        a
“Train ”). ProEco Shareholders will receive 60% of the Transaction Shares at the
        time of the closing and will receive the remaining 40% of the Transaction
        Shares
        in two equal installments upon the completion of construction of the first
        Train
        (20%) and the commencement of construction of the final Train (20%). The
        remaining 40% of the Transaction Shares will be held in escrow until the
        conditions for their release have been met. The parties intend the transaction
        to qualify as a tax-free reorganization under Section 368(a) of the U.S.
        Internal Revenue Code of 1986, as amended.
 
 The
        Share
        Exchange Agreement requires ProEco to complete a number of steps toward
        completion of the Ethanol Plant project in order for the closing of the share
        exchange to occur. At the time of the closing, ProEco must have entered into
        a
        definitive engineering, procurement and construction ("EPC") contract with
        a reputable firm with extensive experience in implementing and completing
        projects similar to the Ethanol Plant project and executed marketing agreements
        for the sale of the production of the Ethanol Plant. Under the terms of the
        share exchange agreement, ProEco is responsible for having the Ethanol Plant
        designated as a facility nameplated, or certified, as producing ethanol at
        a
        level of at least 100 million gallons of production a year.
  1
  O2Diesel
        Corporation
 (A
        Development Stage Company)
 March 31,
        2007
 
 As
        a
        condition to the closing of the ProEco share exchange, the Company is obligated
        to secure the financing necessary to complete the construction costs to build
        the Ethanol Plant. Accordingly, the Company will be required to
        raise $120 to $140 million in debt and between $60 to $80 million in equity
        in two tranches in 2007.
  Prior
        to
        closing, the Company and the ProEco Shareholders will enter into a stockholder
        agreement that will, among other things, impose restrictions on the transfer
        of
        the Transaction Shares.
  The
        Common Stock will be issued to the ProEco Shareholders in a transaction that
        will be exempt from the registration requirement pursuant to Section 4(2)
        of the Securities Act of 1933, as amended (the “Securities Act”) and under
        Regulation D promulgated under the Securities Act.
  Under
          the
          terms of the letter of intent for the share exchange agreement, the Company
          agreed to enter into a secured loan agreement with ProEco for the purposes
          of
          financing the purchase options for the land to be used for the ethanol
          plant and
          certain engineering and permitting work required for the closing of the
          ProEco
          share exchange. The loan agreement provides for the Company to advance
          ProEco up to $400,000 and has a maturity date of June 22, 2007. The
          interest rate on the loan is 7%. As of March 31, 2007, the Company had
          advanced
          $400,000 to ProEco under the terms of this agreement. As of April 30, 2007,
          the
          Company agreed to extend the maturity date of the loan to September 15,
          2007 and
          anticipates increasing the amount covered under the loan by an additional
          $400,000 for the quarter ending June 30, 2007.
 **$10.0
        million Private Placement**
 
 On
        February 16, 2007, the Company entered into a common stock purchase agreement
        (the “Purchase Agreement”) with Fusion Capital Fund II, LLC, an Illinois limited
        liability company (“Fusion Capital”). Pursuant to the Purchase Agreement, at the
        Company's discretion, the Company may sell up to $10 million of the Company's
        common stock to Fusion Capital from time to time over a 25-month period.
        The
        Company has reserved for issuance up to 12,000,000 shares of the Company's
        common stock for sale to Fusion Capital under this agreement. Subject to
        earlier
        termination at the Company's discretion, Fusion Capital's purchases will
        occur
        after the SEC has declared effective the registration statement related to
        the
        transaction. The Company has issued to Fusion Capital 805,987 shares of the
        Company's common stock as a commitment fee for entering into the Purchase
        Agreement.
 
 Concurrently
        with entering into the Purchase Agreement, the Company entered into a
        registration rights agreement with Fusion Capital (the “Registration Rights
        Agreement”). Under the Registration Rights Agreement, the Company agreed to file
        a registration statement with the SEC covering the shares that have been
        issued
        or may be issued to Fusion Capital under the Purchase Agreement. After the
        SEC
        has declared effective the registration statement, generally the Company
        has the
        right but not the obligation from time to time to sell shares of the Company's
        common stock to Fusion Capital in amounts between $100,000 and $1 million
        depending on certain conditions. The Company has the right to control the
        timing
        and amount of any sales of the Company's shares to Fusion Capital. The purchase
        price of the shares will be determined based upon the market price of the
        shares
        of common stock without any fixed discount. Fusion Capital does not have
        the
        right or the obligation to purchase any shares of the Company's common stock
        on
        any business day that the price of the Company's common stock is below either
        $0.50 or $0.60, depending on the transaction size of the purchase. The agreement
        may be terminated by the Company at any time at its discretion without any
        cost
        to the Company.
  **Listing
        of Common Stock on AMEX**
 
 On
        June 15, 2004, the American Stock Exchange (“AMEX” or “Exchange”) approved
        an application to list 46,518,898 shares of our common stock under the symbol
        OTD. Subsequent to this date, the Exchange has approved additional applications
        to list 60,849,310 more shares of our common stock so that the total number
        of
        shares approved for listing is 107,368,208. Our shares began to trade on
        the
        Exchange on July 1, 2004.
 
 The
        Company’s audited consolidated financial statements for the year ended
        December 31, 2006, were prepared on a going concern basis, which
        contemplates the realization of assets and the settlement of liabilities
        and
        commitments in the normal course of business. Our independent registered
        public
        accounting firm included an explanatory paragraph in their report on the
        December 31, 2006 audited consolidated financial statements to highlight
        that the Company’s accumulated losses and working capital deficit raised
        substantial doubt about the Company’s ability to continue as a going
        concern.
 
 The
        Company’s unaudited financial statements for the three months ended
        March 31, 2007, have been prepared on a going concern basis, which
        contemplates the realization of assets and the settlement of liabilities
        and
        commitments in the normal course of business. At March 31, 2007, the
        Company had a working capital surplus of $4,559,183 and had
        accumulated losses of $35,490,974.
 
 Further,
        the Company was notified in December 2004 by the AMEX that it was not in
        compliance with the listing standards of the Exchange because it lacked the
        requisite amount of stockholders’ equity. AMEX requires that minimum levels of
        stockholders’ equity be maintained. O2Diesel was not in compliance because its
        stockholders’ equity had dropped below the required minimums, and it had
        experienced continuing losses for the past four years. In order to return
        to
        full compliance, O2Diesel needed to have stockholders’ equity of
        $6.0 million by June 2006 and to maintain this level going
        forward.
 
 2
  O2Diesel
        Corporation
 (A
        Development Stage Company)
 March 31,
        2007
 
 In
        accordance with the procedures of the Exchange, we filed a plan (“Plan”) with it
        to demonstrate the steps we would take to return to full compliance. On
        February 15, 2005, the AMEX notified us that it had accepted our Plan, and
        that we would be given until June 2006 in which to regain compliance with
        the Exchange’s listing rules. To achieve that level of stockholders’ equity, we
        anticipated having to raise a total of approximately $10.0 million in new
        equity during 2005. In December 2005, the Company determined that it could
        not meet certain conditions of the Plan and met with representatives of the
        AMEX
        to discuss the need to develop an amended plan to demonstrate how the Company
        would be in compliance by June 2006. During 2006, as part of its efforts to
        meet these requirements, the Company closed an offer to existing warrant
        holders
        to exercise their warrants at a reduced price for proceeds of approximately
        $1.5
        million (after expenses) and three private placements totaling
        $7.5 million.
 
 On
        July
        17, 2006, the Company received a letter from the AMEX indicating that the
        Company had regained compliance with AMEX listing requirements. At December
        31,
        2006, the Company was in compliance with AMEX listing requirements, but for
        the
        period ended March 31, 2007, the Company was not able to meet the listing
        requirements. However, as described above, the Company has entered into a
        common
        stock purchase agreement to raise up to $10 million in new equity in 2007,
        which
        we believe will enable us to meet or exceed these requirements, once the
        registration statement for such shares is declared effective by the SEC.
 
 If
        the
        Company were to fail to return to full compliance with the Exchange’s listing
        standards, the AMEX would likely initiate procedures to de-list the Company’s
        common stock. If the Company’s common stock were to be de-listed by the AMEX,
        its shares would continue to be traded as a bulletin board stock.
 
 **Operations**
 
 During
        the first quarter of 2007, we continued our efforts to generate sales to
        our
        targeted fleet customers in North America and Brazil, as well as our efforts
        to
        develop targeted demonstrations in Europe. At the same time, the Company
        began
        significant transactions with its Asian partner, Energenics Pte Ltd
        ("Energenics").
 
 United
        States and Canada:
 
 Our
        focus
        for the U.S. and Canada is to target key geographical areas and specific
        diesel
        markets based upon:
 
 **Ø**
              
              Current
                  and projected quantity of diesel fuel consumption;**Ø**
              
              High-population
                  centers under strict air quality regulations;**Ø**
              
              Municipal
                  transit and school bus fleets with an emphasis on public policy
                  and a
                  positive environmental image;**Ø**
              
              Large
                  concentrations of urban-based, centrally fueled fleets of trucks
                  and
                  buses;**Ø**
              
              Off-road
                  construction equipment;**Ø**
              
              Diesel
                  equipment used by port facilities and large-scale mining operations;
                  or**Ø**
              
              Military
                  installations in non-combat
                  vehicles.
 
 In
        the
        U.S., O2Diesel's first quarter sales and marketing efforts for fleet sales
        were
        focused in the state of California and in the Midwest. In Canada, we intend
        to
        focus our efforts on the country's large population centers in the Eastern
        and
        Western provinces, but until we have commercialized our technology in the
        U.S.,
        no significant resources will be devoted to Canada.
 
 In
        the
        first quarter of 2007, the Company continued its commercial activities at
        the
        Port of Long Beach and is currently pursuing additional opportunities in
        this
        market segment. The Company also announced that the U.S. Air Force had approved
        the expansion of its successful test demonstration with a USAF base in Nevada,
        both in the number of vehicles to be used and the length of time the
        demonstration will now run. The Company was able to successfully conclude
        its
        test demonstration in Clark County, Nevada, which was devoted to documenting
        the
        reduced emmission benefits of O2DieselTM over a range of temperatures and engine
        types.
 
 We
        also
        continued to devote resources to our CityHomeTM demonstration program as a means
        of accelerating sales and developing operating and performance data. CityHomeTM
is marketing and sales initiative directed at city and recently school transit
        agencies across the United States as an opportunity to improve air quality
        in
        urban locations. This program stresses the environmental benefits of our
        fuel
        and is designed to allow municipal transit authorities to convert their fleets
        to O2DieselTM without having to pay the higher costs of our fuel.
  3
 
 O2Diesel
        Corporation
 (A
        Development Stage Company)
 March 31,
        2007
 
 Through
        an innovative cost sharing concept with companies that wish to be good corporate
        citizens (sponsors), we have designed a program which permits the municipalities
        to purchase our fuel at costs which are the same as what they pay for regular
        diesel fuel. Corporate sponsors, generally with a national or international
        presence, will pay sponsorship fees to O2Diesel to take part in a clean air
        program for one or more of the communities participating in a CityHomeTM program.
        In return for sponsorship payments, each sponsor will be given access to
        currently unused advertising space on buses and other advertising assets
        owned
        by the municipality. Sponsorship fees will become additional revenue for
        us and
        will be recognized as such when the related advertising is displayed and
        all
        other criteria for revenue recognition have been met. Costs that are intended
        to
        be supported by the sponsorship fees are recorded separately in the related
        expense line in our statement of operations. With regard to the advertising
        space, since the CityHomeTM program is still in a relatively undeveloped phase
        and since we have been unable to assess the fair market value of the advertising
        space received, we assign no value to the space at the time of the receipt.
        We
        are recognizing the value associated with the advertising space when we enter
        into a contractual arrangement with a third party. The Company will consider
        assigning a fair value to the advertising space received at the time of the
        initial sale when such fair value is more readily determinable, based upon
        a
        history of cash transactions.
 
 In
        the
        first quarter of 2007, we had CityHomeTM installations with four municipal bus
        fleets, as well as a Midwestern operator of both school and tour bus fleets
        and
        a company with a small school bus fleet in Chicago. In March 2007, the Company
        announced the addition of a third small bus fleet in South Dakota. To date,
        we
        have used this initiative as an important component of our test/demonstration
        strategy and have been successful in attracting fuel distributors to work
        with
        us in getting this initiative started. However, while we have received
        sponsorship funding for our current CityHomeTM programs, several fleet
        demonstrations being executed under this program have continued to require
        significant financial support from the Company. As a result, we have limited
        new
        CityHomeTM programs to instances where we are assured of a level of sponsorship
        funding needed to cover all expenses of the demonstration. As of May 15,
        2007,
        we concluded our demonstration in the Springfield, Illinois CityHome municipal
        bus fleet and reduced our participation in the Des Moines, Iowa CityHome
        fleet
        to a small number of vehicles due to previously reported issues relating
        to
        continued water contamination of the fuel supplied to those fleets.
 
 We
        have
        also continued our efforts to establish and improve the logistics network
        required for the delivery of O2DieselTM to fleet and CityHomeTM customers during
        the first quarter. These efforts have centered on developing strategic
        relationships with ethanol producers and distributors in order to improve
        both
        quality consistency and price stability. As of March 31, 2007, the Company
        had
        succeeded in negotiating supply agreements with two ethanol industry groups
        to
        obtain a supply of limited amounts of ethanol at preferential pricing for
        our
        Midwestern customers.
 
 In
        addition, as discussed above, the Company entered into an agreement to acquire
        an 80% ownership share in ProEco, which is planning to build a 100 million
        gallon ethanol plant in South Dakota. Once this acquisition has closed and
        the
        plant is operational, it is expected that this facility will provide a reliable
        source of high quality, competitively priced ethanol for the Company to use
        in
        developing the U.S. market. During the first quarter of 2007, the Company
        worked
        in support of ProEco to obtain options for land purchase, the submission
        of
        permits for construction, the negotiation of an EPC contract, the negotiation
        of
        supply and transportation agreements and the development of marketing agreements
        for sale of the ethanol to be produced at this facility.
 
 We
        are
        continuing a series of product tests and demonstrations that relate directly
        to
        obtaining regulatory approval for O2DieselTM and which are designed to meet the
        needs of our targeted customers. During the quarter ended March 31, 2007,
        the
        Company continued its efforts to register O2DieselTM fuel with the EPA and
        continued to conduct a revised series of tests to qualify O2DieselTM as a
        California Diesel Emissions Control Strategy (DECS) both as a stand alone
        fuel
        and in conjunction with various exhaust after treatment devices, such as
        both
        direct oxidation catalysts (DOC's) and Diesel Particulate Filters (DPF's).
 
 In
        addition, we continued to develop a revised ballot for incorporation of our
        fuel
        as an American Society for Testing and Materials (ASTM) specification. This
        revision is based on the results of the initial voting on the original ballot
        submitted in December 2006. A member of the Company serves as the chairman
        of
        the subcommittee tasked with revising this ballot and it is expected to be
        re-submitted during the second quarter of 2007 so that it can be discussed
        and
        voted on during the June 2007 ASTM international meeting.
 
 Finally,
        during the first quarter we continued to develop contract proposals for
        submission to the Department of Energy and the Department of Defense to utilize
        the $2.0 million of available appropriations received in prior years. These
        appropriations were awarded for the purpose of continued testing and
        verification of O2DieselTM, including the requirements of both DECS and the U.S.
        military.
 
 4
 
 O2Diesel
        Corporation
 (A
        Development Stage Company)
 March 31,
        2007
 
 Brazil:
 
 In
        Brazil, O2Diesel is targeting customers on a very focused basis. In general,
        these will be miller fleets (sugar and ethanol producers), municipal bus
        and
        other fleets, and to a lesser extent centrally fueled truck fleets. We have
        established a small sales force and technical staff in Brazil. The roll out
        of
        our product has been much slower than planned. Obtaining government approvals
        and gaining market awareness has taken longer than we anticipated. In addition,
        the cost of ethanol in Brazil remains relatively high, making it difficult
        to
        produce our blended fuel at a cost competitive level. In response to these
        matters, we have made a decision to follow a less aggressive marketing strategy
        for Brazil. We have taken steps to reduce our overhead and scaled back our
        marketing plans until we have a solid base of customers in Brazil. During
        the
        first quarter of 2007, we continued our support of one test fleet and entered
        into negotiations with a municipal bus fleet in Curitiba.
 
 Brazil's
        fuel distribution system is more concentrated than in the U.S. As a consequence,
        O2Diesel must join with one or more large fuel distributors that can blend
        and
        deliver O2DieselTM to customers in Brazil. O2Diesel currently cooperates on a
        non-exclusive basis with Brazil's largest fuel distributor, BR, the distribution
        arm of the state-owned mineral oil company Petrobrás. Failure to attract
        additional distribution partners to cover other parts of Brazil will likely
        set
        back our timetable for achieving market penetration in that
        country.
 
 Europe:
 
 During
        the first quarter of 2007, we pursued additional discussions and initiatives
        in
        Europe to test our fuel and to determine the market size and regulatory hurdles
        to be overcome to gain wider acceptance of our fuel in Europe. As of March
        31,
        2007, the Company had identified two municipal transit fleets, a waste fleet
        and
        a port facility that were interested in evaluating O2DieselTM fuel during test
        demonstrations. We expect these activities to develop into demonstration
        programs within the next two quarters.
 
 Asia
 
 In
        Asia,
        the company who serves as our exclusive distribution agent announced that
        it had
        concluded a successful trial demonstration of the fuel. In addition, we
        commenced supplying the first 2,500 buses of a large municipal fleet in
        Karnataka, India. For the quarter ended March 31, 2007, the Company had recorded
        sales to this customer of $143,617.
 
 Technical
        and Logistical Issues
 
 Significant
        technical and logistical issues continued to affect our ability to generate
        sales in the first quarter of 2007. While we have made substantial progress
        in
        addressing these challenges over the course of the year, they have impeded
        our
        efforts to commercialize O2DieselTM fuel. In general, these challenges fall into
        the following categories: (1) logistics of delivering and dispensing
        O2DieselTM, (2) sourcing and installation of flame arrestors and other
        devices in vehicles and storage facilities, (3) negotiating reliable,
        price-competitive supplies of fuel grade ethanol, (4) insuring that fuel
        tanks are appropriately cleaned, and (5) obtaining regulatory approval and
        an
        industry accepted specification for our “e-diesel” (ethanol-diesel) fuel.
        O2Diesel has devised several strategies to meet these challenges and has
        undertaken a variety of activities to overcome these challenges and to position
        O2DieselTM as a premium clean-burning fuel.
 
 Under
        the
        first element of our strategy, we have signed distribution agreements with
        thirteen jobbers, who in turn have centrally fueled fleets as their customers.
        We sell additive to these jobbers and assist them in purchasing ethanol by
        either locating ethanol suppliers or purchasing and reselling ethanol to
        them.
        However, we will only purchase ethanol as an accommodation to a jobber, because
        we do not wish to tie-up our limited working capital to finance the purchases
        of
        ethanol. The jobbers blend our additive and ethanol with diesel fuel and
        then
        sell O2DieselTM to their customers. O2Diesel's sales force and technical staff
        work jointly with each jobber and the jobber's customers to assist in the
        transition from the use of regular diesel fuel to O2DieselTM. A key part of
        working with each jobber and its customers is to provide safety and training
        materials covering the use of the fuel. In addition, O2Diesel's technical
        staff
        works closely with each customer in the process of purchasing and installing
        flame arrestors and other devices for customer vehicles and storage facilities.
        In some cases, we are responsible for sourcing and installing these devices
        while, in other cases, our technical staff will only have an oversight role.
        Finally, our technical staff will work with the customer to insure that its
        storage facilities are clean and are compatible for storing and dispensing
        O2DieselTM.
 
 In
        addition, our sales force plans to market and sell O2DieselTM directly to
        companies, governmental port facilities and others that operate large centrally
        fueled fleets. These customers may include large truck and bus fleets,
        construction municipalities, and mining companies as well as port cargo handling
        facilities and agricultural users. To date, these customers have only included
        centrally fueled truck fleets and cargo handling facilities at a major port.
        In
        these transactions, the Company will maintain a similar working relationship
        with the customer's blending facilities and staff as it does with third party
        jobbers.
  5
 
 O2Diesel
        Corporation
 (A
        Development Stage Company)
 March 31,
        2007
 
 Secondly,
        as part of the process by which O2DieselTM was approved for sale in California,
        the California Air Resources Board set a number of conditions that we must
        adhere to on an ongoing basis. One of the conditions is that all storage
        tanks
        in which O2DieselTM is stored and all vehicles that use the fuel must be fitted
        with devices known as flame arrestors. Flame arrestors are safety devices
        which
        are intended to prevent a fire in case a spark or other type of ignition
        might
        inadvertently enter the fill inlet of a fuel tank. Imposing this requirement
        proved to be a serious issue prior to 2006, and negatively impacted our ability
        to efficiently commercialize our technology in the U.S. Even though flame
        arrestor technology has been used for many years in other applications, flame
        arrestors in the required sizes and designs were not available as an "off
        the
        shelf item" for use with O2DieselTM during this time. At the beginning of 2007,
        the flame arrestor challenge had been largely resolved for the vehicles within
        O2Diesel's target markets.
 
 Third,
        we
        have confirmed that it is important to carefully select ethanol suppliers
        because there is a wide range of fuel grade ethanol in the marketplace. It
        is
        critical that the ethanol component of O2DieselTM be of a consistently high
        quality and that it meet certain other specifications. Selection of ethanol
        suppliers and creating a relationship with those that can provide the quality
        of
        product we require is a significant need, and is a task that we will devote
        more
        time to during 2007. We are currently working closely with the industry to
        identify ethanol suppliers who meet our criteria. As of March 31, 2007, we
        had
        continued to maintain contracts with two ethanol industry groups to provide
        a
        supply of limited amounts of ethanol at preferential pricing for our Midwestern
        customers.
 
 In
        order
        to ensure fuel quality, we have developed a quality control function that
        constantly tests the ethanol used by all customers. In addition, we have
        learned
        that it is necessary to test the quality of diesel blended with our additive
        and
        ethanol. Establishing our own laboratory facility has been a significant
        help to
        us in developing quality control standards, and for carrying out the tests
        that
        are necessary in preparing a fleet for conversion to use O2DieselTM.
        Additionally, the Company has installed several testing devices in the field
        so
        that samples can be evaluated more efficiently than with a centralized
        laboratory alone. None of these tests are time consuming or technically
        difficult, but they are critical to ensuring that our product functions as
        intended. As we gain more experience, it may not be necessary to conduct
        the
        level and frequency of tests that we expect to do over this coming
        year.
 
 The
        Company has seen that even with a reliable supplier, the price of ethanol
        can be
        volatile as a result of a number of factors, such as the overall supply and
        demand, the level of government support, and the availability and price of
        competing products. For example, many petroleum refiners have recently replaced
        methyl tertiary butyl ether (MBTE) in gasoline with ethanol during the second
        quarter of 2006. The replacement of this ingredient in gasoline has caused
        the
        demand for ethanol to increase dramatically, with a corresponding increase
        in
        its price. A benefit of this phenomenon has been to increase the availability
        of
        ethanol at petroleum terminals when compared to the recent past. However,
        the
        rise in the cost of ethanol has made the price of O2DieselTM fuel increase in
        relation to conventional diesel fuel during the first quarter of 2007. It
        is the
        Company's strategy to help control the costs of ethanol and reduce short-term
        exposure to price fluctuations by continuing our contracts with the ethanol
        industry groups for limited amounts of ethanol at preferred prices and
        purchasing ethanol from the proposed plant to be built by ProEco.
  Another
        concern we have relates to the logistics and storage of O2DieselTM for fleets and
        other diesel equipment that may use the fuel. In particular, it is very
        important that storage tanks be cleaned prior to the introduction of O2DieselTM
into the customer's refueling station. We have made important strides in
        working
        with customers to insure that their storage facilities are compatible with
        O2DieselTM and have now included this step as a critical component of our
        implementation planning process.
 
 The
        Company has taken several steps prior to 2007 to overcome these problems
        and to
        support the introduction of O2DieselTM fuel to new customer opportunities. First,
        we assembled our knowledge and documentation regarding the design requirements
        of flame arrestors in the market areas we served and developed a catalogue
        of
        flame arrestors and parts that can be used for a wide variety of engine/vehicle
        types and customer applications. Second, we developed a checklist of procedures
        to be used by our technicians (in conjunction with our customer) that enabled
        our technicians to prepare a comprehensive fleet profile of hardware
        requirements, tank cleaning procedures and the time required to perform the
        work
        necessary to bring a fleet on-line. Third, we have identified several equipment
        vendors who we plan to work with so that needed equipment can be delivered
        to
        customer locations quickly and at competitive prices. Fourth, we have developed
        a training program that will enable our technicians to teach our customer's
        fleet maintenance staff about handling and storing O2DieselTM fuel, fleet
        modification and maintenance issues that can be expected. Finally, we have
        developed a modest parts inventory at our laboratory facility so that in
        the
        event of an emergency, required parts can be supplied to our
        customers.
 
 6
  O2Diesel
        Corporation
 (A
        Development Stage Company)
 March 31,
        2007
 
 Our
        present planning methodology is based on a 40-day implementation time frame
        that
        requires the project to be a joint effort utilizing the customer's employees
        and
        identifies the timing and costs that the customer can expect. During 2005,
        we
        continued the research and development efforts begun in 2004 to design and
        to
        identify flame arrestors, adaptors and other equipment for vehicles that
        use
        O2DieselTM. Some of these devices have undergone and passed tests to insure that
        they are capable of complying with all required specifications. In 2006,
        other
        flame arrestors were developed and subjected to the required tests. In addition,
        we have learned that certain engines require the fitting of a primer pump
        to
        insure that the vehicle starts and runs properly in hot weather. These devices
        are simple and readily available and the costs are known, but the necessity
        of
        adding these devices to certain vehicles could increase our costs and may
        increase the time required to transition a fleet from using regular diesel
        fuel
        to the use of O2DieselTM. Lastly, in some buses, we have had to install safety
        fueling devices in the fuel inlet that serve the function of flame arrestors,
        but are generally more expensive. These particular devices are readily available
        in the market. To support our implementation efforts, we commissioned a third
        party engineering consulting firm to review our written safety training
        procedures as well as to conduct on-site reviews of four of our customer
        locations in order to evaluate the adequacy of the training and the quality
        of
        safety procedure implementation. The ensuing report from the consultant
        indicated that our safety program requirements were well conceived and were
        being followed quite closely at all locations. Additional safety procedures
        to
        enhance this program are currently being evaluated.
 
 All
        of
        these issues have led to a greater lead time than expected to convert a fleet
        from using regular diesel to O2DieselTM. In fact, we have seen that the time it
        takes to do the conversion work can be the most important factor in bringing
        on
        more customers to use our fuel. As a means of mitigating the time required
        for
        converting a fleet, we have sought to have our customers to complete much
        of
        this work under our direction. However, this policy is dependent upon obtaining
        an agreement from the customer to do the work. The actual time required to
        convert a fleet to use O2DieselTM may be further limited by the availability of
        the customers' vehicles to be in one place long enough to effect the required
        changes. In some cases for safety, insurance or union reasons, customers
        will
        require that they complete all of the work necessary for their vehicles and
        diesel powered equipment to use O2DieselTM, as well as arranging to insure that
        their storage and dispensing facilities are compatible with the use of the
        fuel.
        The Company anticipates that the work achieved prior to 2007 will allow us
        to
        bring all of these factors into the implementation planning process so that
        we
        can avoid the costs and delays we experienced in the past.
 
 The
        technical challenges over this past year have presented significant hurdles
        to
        commercializing our technology. In most cases, we have overcome these obstacles
        by the application of technical resources, payments to support our customers
        and
        a high level of customer service. All of this has been time-consuming and
        has
        slowed our ability to bring our product to market. But it has also created
        a
        base of knowledge which is helpful as we continue our efforts to commercialize
        our technology in the U.S., Europe and other markets. We have been encouraged
        by
        the fact that among our customers, we have a municipal bus fleet and a port
        facility that have been successfully utilizing the fuel for more than one
        year.
        Even though we have gained a significant amount of technical knowledge, we
        will
        continue to refine our efforts in this area in order to improve our ability
        to
        bring on greater numbers of customers and to better predict the cost and
        timing
        of the work required to have fleets conform to the requirements of using
        our
        product.
 
 **First
        Quarter Summary**
 
 Operating
        results during the period ended March 31, 2007 were mixed in comparison to
        the period ended March 31, 2006. Sales improved significantly from $38,125
        (quarter ended March 31, 2006) to $165,963 (quarter ended March 31,
        2007) due in large part to the second major shipment of additive to our Asian
        distributor. Cost of goods sold increased by $103,296 reflecting not only
        the
        increase in sales activity, but also an increase in the costs of the raw
        material components used to manufacture our additive. Selling and marketing
        expenses for the period ended March 31, 2007 were approximately $80,000
        higher than during the period ended March 31, 2006, reflecting the addition
        of personnel and consulting expenses in our Spanish subsidiary, which was
        not
        fully operational in the first quarter of 2006. Product testing and government
        grant (net) expenses in the quarter ended March 31, 2007 were
        approximately $125,000 higher than in the period ended March 31, 2006 due
        to an
        increase in outside contractor charges that were not eligible for reimbursement
        as of March 31, 2007. General and administrative expenses for the quarter
        ended
        March 31, 2007 were approximately $510,000 higher than for the quarter
        ended March 31, 2006 due to the greater payroll expenses of $181,517
        associated with an officer’s restricted stock award in January 2007, increased
        international travel expenses of $70,858 and higher legal costs of $104,217
        in
        comparison to the period ended March 31, 2006. In addition, general and
        administrative costs reflected an increase of $26,686 in the recognition
        of
        share-based compensation expense required by SFAS 123(R) versus the same
        period
        in 2006.
 
 **Cash
        Requirements, Liquidity and Risk Factors**
 
 Based
        on
        our projected level of expenses and the cash on hand as shown on our
        consolidated balance sheet at March 31, 2007, we will need to raise additional
        funds in 2007 to allow us to execute our business plan and to be in compliance
        with the AMEX's listing standards.
  7
 
 O2Diesel
        Corporation
 (A
        Development Stage Company)
 March 31,
        2007
 
 To
        date,
        we have not had any bank trade facilities, except an overdraft line in the
        U.K.
        used to meet operating needs and a small vehicle loan, both of which have
        been
        paid and canceled prior to 2007. However if the Company achieves significant
        sales, we plan to apply for trading lines with banks in the U.S. and Brazil
        as a
        means to finance our working capital needs. In the first quarter of 2007,
        the
        Company continued to have favorable trade terms with its supplier, Cognis
        Deutschland GmbH (“Cognis”) for the supply of additive.
 
 AMEX
        requires that minimum levels of stockholders' equity be maintained. In December
        2004, the Company was notified that it was not in compliance because its
        stockholders' equity had dropped below the required minimums, and it had
        experienced continuing losses for the past four years. In order to return
        to
        full compliance, O2Diesel needed to have stockholders' equity of
        $6.0 million by June 2006 and maintain this level going forward.
        In accordance with the procedures of the AMEX, we filed a plan (“Plan”) with it
        to demonstrate the steps we will take to return to full compliance. On
        February 15, 2005, the AMEX notified us that it had accepted our Plan, and
        that we would be given until June 2006 in which to regain compliance with
        the
        AMEX's listing rules. To achieve that level of stockholders' equity, we
        anticipated having to raise a total of approximately $10.0 million in new
        equity during 2005. In December 2005, the Company determined that it could
        not
        meet certain conditions of the plan and met with representatives of the AMEX
        to
        discuss the need to develop an amended plan to demonstrate how the Company
        would
        be in compliance by June 2006. During 2006, as part of its efforts to meet
        these requirements, the Company closed an offer to existing warrant holders
        to
        exercise their warrants at a reduced price for proceeds of approximately
        $1.5
        million (after expenses) and three private placements totaling
        $7.5 million.
  On
        July
        17, 2006, the Company received a letter from the AMEX indicating that the
        Company has regained compliance with AMEX listing requirements. The Company
        remained in compliance with the AMEX listing standards as of December 31,
        2006.
        However, for the quarter ended March 31, 2007, the Company did not meet the
        listing standards with regard to the need to have stockholder’s equity of $6.0
        million. As described in more fully described above in the “$10.0 million
        Private Placement” section, the Company has negotiated additional common stock
        purchases of up to $10.0 million for use as working capital and to execute
        its
        business plan. We believe that this new equity will enable us to meet or
        exceed
        the AMEX listing requirements once the registration statement for such shares
        is
        effective.
 
 As
        a
        result of the lack of a sales history for our products, we do not have
        sufficient historical financial data for any periods on which to accurately
        forecast future revenues or operating expenses in connection with achieving
        such
        revenues. As such, we are not able to project with certainty the additional
        funds that may need to be raised. In 2006, we raised new equity of approximately
        $9.0 million, before payment of expenses. The Company has recently
        negotiated new equity up to $10.0 million. As stated previously, even with
        the
        fund raising completed in 2006 and early 2007, we will need to raise additional
        equity during this year. We continue to hold discussions with a number of
        potential investors and work with a professional investor relations service
        company to assist with these efforts. In connection with our efforts to attract
        new investment, there can be no assurance that we will be successful in doing
        so. Nor can there be any assurance that the Company will generate sales and
        sponsorship fees followed by the collection of cash to offset our operating
        expenses.
 
 As
        shown
        in the consolidated statements of operations contained in this report, we
        have
        generated only $165,963 in sales and had sponsorship income of $15,750
        associated with the CityHomeTM programs for the three months ended March 31,
        2007. As of the date of this report, we have only minimal orders on hand
        for
        either O2D05 or O2DieselTM, other than our supply requirements for Energenics.
        Lastly, there can be no assurance that actual events will not differ from
        those
        anticipated, or that general economic conditions may not vary significantly
        in
        ways that could negatively impact our operations and cash position.
 
 **Research
        & Development**
 
 The
        Company has 109 patent applications covering eight different fuel and additive
        inventions relating to proprietary products registered with the international
        WIPO (PCT) Registration System. Four inventions currently have patents granted
        in a total of 32 countries in Europe, North America, Central America and
        Asia.
        An additional twelve applications relating to these inventions are pending.
        The
        other four inventions are either undergoing examination at the national level
        or
        are about to do so in various countries. If successful, these other four
        inventions could add up to 65 additional granted patents over the next two
        years. During this period, O2Diesel's intellectual property rights over its
        additive products are protected through its registration with the WIPO (PCT)
        Registration System and its pending national patent applications.
 
 As
        part
        of our cooperation agreement with Cognis, we, along with Cognis, are the
        joint
        owners of all patents covering both the use and composition of O2D05. All
        legal
        costs associated with preparing, filing and administering the jointly owned
        patents are shared equally by the Company and Cognis. We also have a number
        of
        patents that have been issued that relate to the predecessor technology of
        O2D05. As a strategic measure, we continue to fund all costs necessary to
        maintain some of these patents. O2Diesel is the sole owner of these latter
        patents, which in general cover the use and composition of its prior generation
        technology.
  8
  O2Diesel
        Corporation
 (A
        Development Stage Company)
 March 31,
        2007
 
 We
        have
        registered a trademark in the U.S. and the European Union for a mark which
        includes the words and numbers O2DieselTM as well as a figurative logo of the
        words. We also registered trademarks for “CityHome” (and design) in eight
        classes of goods and services, “TODAY'S CLEAN AIR SOLUTION TOMORROW'S BRIGHTER
        FUTURE” and “CITYHO2ME”, each covering one class of goods and services.
 
 The
        Company has incurred substantial costs in carrying out tests to demonstrate
        that
        the use of our product will enable customers to comply with environmental
        laws
        and regulations. As of March 31, 2007, we incurred external expenses of $199,650
        during 2007 in the U.S. in connection with governmental sponsored projects
        and
        tests. Most of the costs incurred in these government test programs will
        be reimbursed by appropriations from the U.S. Departments of Energy and
        Defense.
 
 At
        the
        end of the first quarter of 2007, we had government test programs in progress
        with total remaining costs to complete of approximately $1.0 million. Under
        these programs, a wide array of engine tests and product demonstrations are
        to
        be conducted to further prove the emissions benefits of O2DieselTM and to show
        that the fuel performs well in specific applications.
 
 Included
        in the foregoing programs are a project to develop a fuel that would meet
        EPA's
        alternative fuel requirements for the military, recently expanded product
        demonstrations in Nevada to test O2DieselTM in non-tactical military equipment,
        efforts to complete the protocols to allow O2DieselTM to be classified as a
        Diesel Emissions Control Strategy fuel by the California Air Resources Board
        and
        a project to obtain a military procurement specification for the fuel. Based
        on
        the government funding in place, we believe that approximately 80% of the
        costs
        to conduct these tests may be funded by appropriations from the U.S. Departments
        of Energy and Defense. All of these test procedures are complicated and may
        take
        considerable time to complete. At this point, we are at an early stage so
        that
        it is not possible to predict when this work will be completed or if we will
        obtain the desired results once it is completed.
 
 O2DieselTM
        is conducting demonstrations with a number of school bus and transit agencies
        testing O2DieselTM as well as O2DieselTM blended with B20 in various weather
        conditions, engine types, and uses. We are also working to refine our additive
        formulation in order to reduce its cost and increase its performance. We
        expect
        this work to continue in 2007. In this regard, we have registered a second
        additive package with the Environmental Protection Agency that is more robust
        with respect to water tolerance.
 
 **Employees**
 
 As
        of May
        15, 2007, O2Diesel had eighteen full-time employees, seventeen of which are
        in
        the U.S. and one is in Europe. We had one part-time employee. Currently,
        we rely
        on consultants to assist in commercializing our technology and to help us
        in key
        technical areas. At present, we employ seven consultants in the U.S.; four
        in
        marketing and business development; one laboratory technician, one chemist;
        and
        one in regulatory affairs. The Company has entered into separate consulting
        contracts with two shareholders of its Brazilian subsidiary for the purpose
        of
        providing office rent and administrative services and in lieu of employment
        contracts with these two individuals. In Europe, we employ two consultants,
        one
        for general management and business development and one for regulatory
        affairs.
 
 We
        will
        add new personnel in 2007 based on the pace of our commercialization. Under
        our
        business plan, we do not see the need to add employees in the U.S. or Brazil,
        but we do plan to add technical positions for our European market testing
        and
        development in 2007. We anticipate continuing to employ a total of eleven
        consultants serving in most of the same capacities in 2007.
 
 **ITEM
        3. CONTROLS AND PROCEDURES.**
 
 EVALUATION
        OF DISCLOSURE CONTROLS AND PROCEDURES. O2Diesel’s Chief Executive Officer and
        Chief Financial Officer have evaluated the effectiveness of O2Diesel’s
        disclosure controls and procedures (as such term is defined in Rules13a-15
        and
        15d-15 under the Securities Exchange Act of 1934, as amended) as of the end
        of
        the period covered by this quarterly report (the “Evaluation Date”). Based on
        such evaluation, such officers have concluded that, as of the Evaluation
        Date,
        O2Diesel’s disclosure controls and procedures are effective.
  CHANGES
        IN INTERNAL CONTROLS OVER FINANCIAL REPORTING. During the most recent fiscal
        quarter, there have not been any changes in the Company’s internal controls over
        financial reporting or in other factors that have materially affected, or
        are
        reasonably likely to materially affect internal controls over financial
        reporting.
 
 **PART
        II. OTHER INFORMATION**
 
 **ITEM
        1. LEGAL PROCEEDINGS.**
 
 None.
 
 9
 
 O2Diesel
        Corporation
 (A
        Development Stage Company)
 March 31,
        2007
 
 **ITEM
        2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
        PROCEEDS.**
 
 **Changes
        to Common Stock During the First Quarter of 2007**
 
 Pursuant
        to the $10.0 million transaction, the Company entered into a common stock
        purchase agreement (the “Purchase Agreement”) which allows, at the Company's
        discretion, the Company to sell up to $10 million of the Company's common
        stock
        from time to time over a 25-month period. The Company has reserved for issuance
        up to 12,000,000 shares of the Company's common stock for sale under this
        agreement. Subject to earlier termination at the Company's discretion, purchases
        will occur after the SEC has declared effective the registration statement
        related to the transaction. The Company issued 805,987 shares of the Company's
        common stock as a commitment fee for entering into the Purchase Agreement.
        Fusionis
        an
“underwriter” within the meaning of the Securities Act.
 
 As
        of May
        15, 2007, no shares had been sold under this agreement.
 
 **SUBSEQUENT
        CHANGES IN SECURITIES**
 
 On
        April
        27, 2007, the Company offered existing warrant holders an opportunity to
        exercise their warrants at the reduced price of $0.50 per share. The warrant
        offer will expire on May 25, 2007. If all eligible warrant holders were to
        exercise their warrants at the reduced price, the Company would receive proceeds
        of approximately $4.3 million. On May 9, 2007, the Company extended this
        reduced
        price offer until June 8, 2007. As of May 15, 2007, the Company amended the
        offer to grant the warrant holders, who tender their warrants, additional
        shares
        of Common Stock if the Company enters into any agreement for the sale of
        shares of Common Stock at less than $0.50 per share prior to June 8,
        2008. As of May 15, 2007, the Company had not determined the number of
        warrant holders intending to exercise this reduced price offer.
 
 **ITEM
        3. DEFAULTS UPON SENIOR SECURITIES.**
 
 Not
        applicable.
 
 **ITEM
        4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.**
 
 None
 
 **ITEM
        5. OTHER INFORMATION.**
 None
  10
 
 **** O2Diesel
        Corporation
 (A
        Development Stage Company)
 March 31,
        2007
 
 **ITEM
        6. EXHIBITS AND REPORTS ON FORM 8-K.**
 The
        following exhibits are filed herewith.
  **Description**10
                .1(1)
                
                Share
                    Exchange Agreement, by and among O2Diesel Corporation, ProEnergy
                    Company,
                    Inc., and its shareholders10
                .2(2)
                
                Common
                    Stock Purchase Agreement, dated as of February 16, 2007, by and
                    between
                    O2Diesel Corporation and Fusion Capital Fund II, LLC10
                .3(2)
                
                Registration
                    Rights Agreement, dated as of February 16, 2007, by and between
                    O2Diesel
                    Corporation and Fusion Capital Fund II, LLC10
                .4(1)
                
                Amendment
                    No. 1 to David Shipman's Employment Agreement*10
                .5(1)
                
                Supply
                    and Distribution Agreement+31
                .1(3)
                
                Certification
                    of the Chief Executive Officer pursuant to Rule 13a-14(a) or
                    Rule 15d-14(a), as adopted pursuant to Section 302 of the
                    Sarbanes-Oxley Act of 200231
                .2(3)
                
                Certification
                    of the Chief Financial Officer pursuant to Rule 13a-14(a) or
                    Rule 15d-14(a), as adopted pursuant to Section 302 of the
                    Sarbanes-Oxley Act of 200232
                .1(3)
                
                Certification
                    of the Chief Executive Officer and Chief Financial Officer pursuant
                    to 18
                    U.S.C. Section 1350, as adopted pursuant to Section 906 of the
                    Sarbanes-Oxley Act of 2002
  (1)
                
                Previously
                    filed as an exhibit to the Company’s annual report on Form 10-KSB for the
                    year ended December 31, 2006, on March 27, 2007, and incorporated
                    herein by reference.(2)
                
                Previously
                    filed as an exhibit to the Company’s current report on Form 8-K on
                    February 20, 2007 and incorporated herein by reference.(3)
                
                Filed
                    herewith.
 
 *
                Indicates
                    a management contract or compensatory
                    plan.
  +
                Certain
                    confidential material contained in the document has been omitted
                    and filed
                    separately with the Securities and Exchange Commission pursuant
                    to Rule
                    406 of the Securities Act of 1933, as amended or Rule 24b-2 of
                    the
                    Securities and Exchange Act of 1934, as
                    amended.
  **12. SIGNATURES**
 Pursuant
        to the requirements of the Securities Exchange Act of 1934, as amended, the
        registrant has duly caused this report to be signed on its behalf by the
        undersigned hereunto duly authorized.
 O2DIESEL
                  CORPORATION
                (Registrant)Date:
                  May 15,
                  2007
              By:
              /s/
                  Alan RaeAlan
                  RaeChief
                  Executive Officer
                (Principal
                  Executive Officer)Date:
                    May 15,
                    2007
              By:
              /s/
                  David H. ShipmanDavid
                  H. ShipmanChief
                  Financial Officer
                (Principal
                  Financial and Accounting Officer)
  11