Form
        10-Q
 
 O2DIESEL
        CORP - OTOD
 
 Filed:
        November 14, 2008 (period: September 30, 2008)
 
 Quarterly
        report which provides a continuing view of a company's financial
        position
  
  Table
        of
        Contents
 10-QPART
                    IItem
                    1.
                Financial
                    Statements
                F-2ITEM
                    2.
                MANAGEMENT
                    S DISCUSSION AND ANALYSIS OR RESULTS OF OPERATION
                1ITEM
                    3.
                QUANTITATIVE
                    AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
                13ITEM
                    4.
                CONTROLS
                    AND PROCEDURES.
                13PART
                    II.ITEM
                    1.
                LEGAL
                    PROCEEDINGS.
                14ITEM
                    1A.
                RISK
                    FACTORS
                14ITEM
                    2.
                UNREGISTERED
                    SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.
                14ITEM
                    3.
                DEFAULTS
                    UPON SENIOR SECURITIES.
                14ITEM
                    4.
                SUBMISSION
                    OF MATTERS TO A VOTE OF SECURITY HOLDERS.
                14ITEM
                    5.
                OTHER
                    INFORMATION.
                14ITEM
                    6.
                EXHIBITS.
                15EX-10.1
                    (Material contracts)EX-31.1
                    (Certifications required under Section 302 of the Sarbanes-Oxley
                    Act of
                    2002)EX-31.2
                    (Certifications required under Section 302 of the Sarbanes-Oxley
                    Act of
                    2002)EX-32.1
                    (Certifications required under Section 906 of the Sarbanes-Oxley
                    Act of
                    2002)


**UNITED
      STATES SECURITIES AND EXCHANGE COMMISSION**




**WASHINGTON,
      DC 20549**




**FORM 10-Q**





x
            **QUARTERLY
                REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
                EXCHANGE ACT OF 1934**




**FOR
      THE QUARTERLY PERIOD ENDED September 30, 2008**




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
            91-2023525(State
                or Other
              Jurisdiction
                of Incorporation)
            (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 x No o




Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, a non-accelerated filer, or a smaller reporting
      company.  See definitions of “large accelerated filer”, “accelerated filer”
and “small reporting company” in Rule 12b-2 of the Exchange Act (Check
      one):




Large
      accelerated filer o Accelerated filer o Non-accelerated filer o Smaller Reporting company x




Indicated
      by check mark whether the registrant is a shell company (as defined in
      Rule 12b-2 of the Exchange Act).


Yes o No x




State
      the
      number of shares outstanding of each of the issuer’s classes of
      common


equity,
      as of the latest practicable date:




As
      of
      November 10, 2008, the registrant had 88,490,174 shares of Common
      Stock,


$0.0001
      par value per share, issued and outstanding







O2DIESEL
      CORPORATION


FOR
      THE
      QUARTER ENDED SEPTEMBER 30, 2008


INDEX
      TO
      FORM 10-Q




PART I
                FINANCIAL INFORMATIONItem 1.
                Financial Statements
            
            F-2Item 2.
                Management’s Discussion and Analysis or Results of
                Operation
            
            1Item
                3. Quantitative and Qualitative Disclosures About Market
                Risk
            
            13Item 4.
                Controls and Procedures
            
            13PART II
                OTHER INFORMATIONItem 1.
                Legal Proceedings
            
            14Item
                1A Risk Factors
            
            14Item 2.
                Unregistered Sales of Equity Securities and Use of
                Proceeds
            
            14Item 3.
                Defaults Upon Senior Securities
            
            14Item 4.
                Submission of Matters to a Vote of Security Holders
            
            14Item 5.
                Other Information
            
            14Item 6.
                Exhibits
            
            15Signatures
            
            15




NOTE
      REGARDING FORWARD LOOKING STATEMENTS




This
      quarterly report on Form 10-Q 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, 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.







**02Diesel
        Corporation**
 **(A
        Development Stage Company)**
  **Consolidated
        Balance Sheets**
  **September
        30, 2008 and December 31, 2007**
 **(Unaudited)**
 
 **September 30,**
                **2008**
              
              **December 31,**
                **2007****ASSETS****CURRENT
                  ASSETS**Cash
              
              $
              36,433
              
              $
              581,645Restricted
                  cash
              
              
              50,456
              
              
              2,333,959Accounts
                  receivable
              
              
              4,225
              
              
              115,536Other
                  receivables
              
              
              236,244
              
              
              192,619Unbilled
                  appropriations receivable
              
              
              -
              
              
              145,576Inventory
              
              
              157,785
              
              
              174,447Prepaid
                  expenses, parts and deposits
              
              
              164,798
              
              
              209,428Total
                  current assets
              
              
              649,941
              
              
              3,753,210**FURNITURE
                  AND EQUIPMENT**Office
                  furniture and equipment
              
              
              231,461
              
              
              268,828Fuel
                  and test equipment
              
              
              341,943
              
              
              382,971573,404
              
              
              651,799Less
                  accumulated depreciation
              
              
              (308,311
              )
              
              (283,742
              )265,093
              
              
              368,057**TOTAL
                  ASSETS**
              
              **$**
              **915,034**
              
              **$**
              **4,121,267****LIABILITIES
                  AND STOCKHOLDERS' EQUITY
                  (DEFICIT)********CURRENT
                  LIABILITIES**Accounts
                  payable
              
              $
              1,337,045
              
              $
              1,774,248Accrued
                  expenses
              
              
              243,615
              
              
              568,442Deferred
                  grants
              
              
              527,311
              
              
              475,980Deferred
                  marketing program
              
              
              -
              
              
              86,333Total
                  current liabilities
              
              
              2,107,971
              
              
              2,905,003Note
                  payable
              
              
              750,000
              
              
              -**TOTAL
                  LIABILITIES**
              
              
              **2,857,971**
              
              
              **2,905,003****STOCKHOLDERS'
                  EQUITY (DEFICIT)**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;84,981,812
                  and 86,666,837 shares issued and outstandingat
                  September 30, 2008 and December 31, 2007, respectively
              
              
              8,498
              
              
              8,667Additional
                  paid-in capital
              
              
              45,307,044
              
              
              45,123,009Unearned
                  compensation
              
              
              -
              
              
              (14,668
              )Accumulated
                  other comprehensive income
              
              
              41,054
              
              
              12,088Deficit
                  accumulated during the development stage
              
              
              (47,299,533
              )
              
              (43,912,832
              )Total
                  stockholders' equity (deficit)
              
              
              (1,942,937
              )
              
              1,216,264**TOTAL
                  LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)**
              
              **$**
              **915,034**
              
              **$**
              **4,121,267**




*See
      Notes to Consolidated Financial Statements*




F-2


**O2DIESEL
      CORPORATION**


**(A
      Development Stage Company)**




**CONSOLIDATED
      STATEMENTS OF OPERATIONS**




**For
      the three and nine months ended September 30, 2008 and 2007 and
      the**


**Period
      from October 14, 2000 (inception) through September 30,
      2008**


**(Unaudited)**


**Three Months Ended**
              
              **Nine Months Ended**
              
              **October 14, 2000**
                **(inception)**
                **through****9/30/08**
              
              **9/30/07**
              
              **9/30/08**
              
              **9/30/07**
              
              **Sepember 30, 2008**Additive
                  related sales
              
              $
              17,258
              
              $
              123,128
              
              $
              37,122
              
              $
              304,126
              
              $
              812,534Sponsorship
                  income
              
              
              -
              
              
              1,875
              
              
              -
              
              
              21,375
              
              
              169,24817,258
              
              
              125,003
              
              
              37,122
              
              
              325,501
              
              
              981,782**Expenses:**Cost
                  of goods sold
              
              
              7,385
              
              
              81,910
              
              
              29,884
              
              
              227,421
              
              
              605,443Selling
                  and marketing
              
              
              236,689
              
              
              439,753
              
              
              663,351
              
              
              1,145,391
              
              
              9,929,316Product
                  testing and government grants, net
              
              
              (40,340
              )
              
              259,651
              
              
              31,213
              
              
              449,316
              
              
              1,630,826General
                  and administrative
              
              
              927,622
              
              
              2,101,332
              
              
              3,313,493
              
              
              5,850,477
              
              
              36,400,923**Total
                  operating expense**
              
              
              1,131,356
              
              
              2,882,646
              
              
              4,037,941
              
              
              7,672,605
              
              
              48,566,508**Operating
                  loss**
              
              
              **(1,114,098**
              **)**
              
              **(2,757,643**
              **)**
              
              **(4,000,819**
              **)**
              
              **(7,347,104**
              **)**
              
              **(47,584,726**
              **)****Other
                  income (expense):**Interest
                  expense
              
              
              (3,907
              )
              
              (3,437
              )
              
              (8,767
              )
              
              (8,343
              )
              
              (141,632
              )Interest
                  income
              
              
              750
              
              
              9,603
              
              
              2,570
              
              
              37,697
              
              
              237,168Foreign
                  currency gain/(loss), net
              
              
              (16,016
              )
              
              148,759
              
              
              84,148
              
              
              230,297
              
              
              889,592Gain
                  on sale of subsidiary
              
              
              483,000
              
              
              -
              
              
              483,000
              
              
              -
              
              
              483,000Other
                  income (expense), net
              
              
              1
              
              
              1,420
              
              
              4,641
              
              
              1,030
              
              
              312,184**Total
                  other income (expense)**
              
              
              463,828
              
              
              156,345
              
              
              565,592
              
              
              260,681
              
              
              1,780,312**Loss
                      from continuing operations before income
                      taxes**
              
              
              (650,270
              )
              
              (2,601,298
              )
              
              (3,435,227
              )
              
              (7,086,423
              )
              
              (45,804,414
              )Income
                  tax (expense) benefit
              
              
              (23,503
              )
              
              -
              
              
              (23,503
              )
              
              -
              
              
              122,139**Loss
                  from continuing operations**
              
              
              **(673,773**
              **)**
              
              **(2,601,298**
              **)**
              
              **(3,458,730**
              **)**
              
              **(7,086,423**
              **)**
              
              **(45,682,275**
              **)**Gain
                  (loss) from discontinued operations
              
              
              89,287
              
              
              (327,216
              )
              
              72,029
              
              
              (327,216
              )
              
              (1,617,258
              )**Net
                  income (loss)**
              
              
              **(584,486**
              **)**
              
              **(2,928,514**
              **)**
              
              **(3,386,701**
              **)**
              
              **(7,413,639**
              **)**
              
              **(47,299,533**
              **)****Deemed
                  dividend to preferred stockholders**
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (6,200,005
              )**Net
                  loss for common shareholders**
              
              **$**
              **(584,486**
              **)**
              **$**
              **(2,928,514**
              **)**
              **$**
              **(3,386,701**
              **)**
              **$**
              **(7,413,639**
              **)**
              **$**
              **(53,499,538**
              **)**Net
                  loss per common share (basic and diluted)
              
              $
              (0.01
              )
              $
              (0.04
              )
              $
              (0.04
              )
              $
              (0.10
              )
              $
              (1.17
              )Weighted
                  average shares of common shares outstanding
              
              
              84,991,314
              
              
              81,751,676
              
              
              84,888,405
              
              
              77,658,507
              
              
              62,238,971Recapitalization
                  resulting from the AAE Technologies International PLC
                  acquisition
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (16,548,323
              )Weighted
                  average shares of common shares outstanding - giving effect to
                  the
                  recapitalization
              
              
              84,991,314
              
              
              81,751,676
              
              
              84,888,405
              
              
              77,658,507
              
              
              45,690,648





*See
      Notes to Consolidated Financial Statements*




F-3




**O2DIESEL
      CORPORATION**


**(A
      Development Stage Company)**





**CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)**




**October 14,
      2000 (inception) through September 30, 2008**


**(Unaudited)**


**Preferred Stock**
              
              **Common Stock**
              
              **Unearned**
              
              **Common**
                **Stock**
              
              **Additional**
                **Paid-In****Shares**
              
              **Amount**
              
              **Shares**
              
              **Amount**
              
              **Compensation**
              
              **Subscribed**
              
              **Capital**Balance
                  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
              
              
              11,745,765





*See
      Notes to Consolidated Financial Statements*




F-4




**O2DIESEL
      CORPORATION**


**(A
      Development Stage Company)**


**CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)**





**October 14,
      2000 (inception) through September 30, 2008 
(Continued)**


**(Unaudited)**


**Preferred Stock**
                
                **Common Stock**
                
                **Unearned**
                
                **Common**
                  **Stock**
                
                **Additional**
                  **Paid-In****Shares**
                
                **Amount**
                
                **Shares**
                
                **Amount**
                
                **Compensation**
                
                **Subscribed**
                
                **Capital**Net
                    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 in 2005
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                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 in 2006
                
                
                —
                
                
                —
                
                
                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
                )
                
                —
                
                
                40,076,305
  *See
        Notes to Consolidated Financial Statements*
  F-5




**O2DIESEL
      CORPORATION**


**(A
      Development Stage Company)**


**CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)**




**October 14,
      2000 (inception) through September 30, 2008 (Continued)**


**(Unaudited)**


**Preferred Stock**
                
                **Common Stock**
                
                **Unearned**
                
                **Common**
                  **Stock**
                
                **Additional**
                  **Paid-In****Shares**
                
                **Amount**
                
                **Shares**
                
                **Amount**
                
                **Compensation**
                
                **Subscribed**
                
                **Capital**Net
                    loss
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —Foreign
                    currency translation adjustment
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —Comprehensive
                    loss
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —Common
                    stock issued to employee
                
                
                —
                
                
                —
                
                
                333,333
                
                
                33
                
                
                —
                
                
                —
                
                
                273,266Fair
                    value of unearned shares related to commitment shares
                
                
                —
                
                
                —
                
                
                805,987
                
                
                80
                
                
                —
                
                
                —
                
                
                668,889Unearned
                    common stock issued for commitment shares
                
                
                —
                
                
                —
                
                
                (465,170
                )
                
                (47
                )
                
                —
                
                
                —
                
                
                (386,044
                )Fusion
                    shares issued at various prices in 2007
                
                
                —
                
                
                —
                
                
                970,994
                
                
                97
                
                
                —
                
                
                —
                
                
                499,903Common
                    stock issued for consulting services
                
                
                —
                
                
                —
                
                
                540,000
                
                
                54
                
                
                —
                
                
                —
                
                
                263,446Common
                    stock issued at $0.405 per share in 2007
                
                
                —
                
                
                —
                
                
                2,993,346
                
                
                299
                
                
                —
                
                
                —
                
                
                1,109,944Repurchase
                    of shares
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —Retirement
                    of repurchased shares
                
                
                —
                
                
                —
                
                
                (100,000
                )
                
                (10
                )
                
                —
                
                
                —
                
                
                (40,090
                )Common
                    stock issued at $0.417 per share in 2007
                
                
                —
                
                
                —
                
                
                3,130,000
                
                
                313
                
                
                —
                
                
                —
                
                
                1,194,821Common
                    stock issued at $0.375 per share in 2007
                
                
                —
                
                
                —
                
                
                3,333,333
                
                
                334
                
                
                —
                
                
                —
                
                
                1,249,666Amortization
                    of unearned compensation
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                110,473
                
                
                —
                
                
                (24,727
                )Fair
                    value of stock options issued in 2006 and 2007
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                237,631Balance
                    at December 31, 2007
                
                
                —
                
                
                —
                
                
                86,666,837
                
                
                8,667
                
                
                (14,668
                )
                
                —
                
                
                45,123,009Net
                    loss
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —Foreign
                    currency translation adjustment
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —Comprehensive
                    loss
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —Unearned
                    common stock issued for commitment shares
                
                
                —
                
                
                —
                
                
                290,141
                
                
                29
                
                
                —
                
                
                —
                
                
                240,793Common
                    stock issued for consulting services
                
                
                —
                
                
                —
                
                
                1,191,501
                
                
                119
                
                
                —
                
                
                —
                
                
                256,131Amortization
                    of unearned compensation
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                14,668
                
                
                —
                
                
                —Fair
                    value of stock options issued in 2006 and 2007
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                33,128Common
                    stock issued to employee
                
                
                —
                
                
                —
                
                
                166,666
                
                
                17
                
                
                —
                
                
                —
                
                
                136,649Treasury
                    stock received in exchange for shares of subsidiary
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —Retirement
                    of treasury stock
                
                
                —
                
                
                —
                
                
                (3,333,333
                )
                
                (334
                )
                
                —
                
                
                —
                
                
                (482,666
                )Balance
                    at September 30, 2008
                
                
                —
                
                $
                —
                
                
                84,981,812
                
                $
                8,498
                
                $
                —
                
                $
                —
                
                $
                45,307,044


*See
      Notes to Consolidated Financial Statements*


F-6


**O2DIESEL
      CORPORATION**


**(A
      Development Stage Company)**





**CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)**




**October 14,
      2000 (inception) through September 30, 2008 (Continued)**


**(Unaudited)**


**Common**
                **Stock**
                **Subscriptions**
                **Receivable**
              
              **Accumulated**
                **Other**
                **Comprehensive**
                **Income (Loss)**
              
              **Treasury**
                **Stock**
              
              **Deficit**
                **Accumulated**
                **During the**
                **Development**
                **Stage**
              
              **Total**
                **Stockholders’**
                **Equity**
                **(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
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              1,218,304Recapitalization
                  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
              )
              
              140,776




*See
      Notes to Consolidated Financial Statements*




F-7


**O2DIESEL
      CORPORATION**


**(A
      Development Stage Company)**





**CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)**




**October 14,
      2000 (inception) through September 30, 2008 (Continued)**


**(Unaudited)**




**Common**
                **Stock**
                **Subscriptions**
                **Receivable**
              
              **Accumulated**
                **Other**
                **Comprehensive**
                **Income (Loss)**
              
              **Treasury**
                **Stock**
              
              **Deficit**
                **Accumulated**
                **During the**
                **Development**
                **Stage**
              
              **Total**
                **Stockholders’**
                **Equity**
                **(Deficit)**Net 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 in 2005
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              63,100Warrants
                  issued for consulting services in 2005
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              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 in 2006
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              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
              )
              
              6,867,856




*See
      Notes to Consolidated Financial Statements*




F-8


**O2DIESEL
      CORPORATION**


**(A
      Development Stage Company)**





**CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)**




**October 14,
      2000 (inception) through September 30, 2008 (Continued)**


**(Unaudited)**


**Common**
                **Stock**
                **Subscriptions**
                **Receivable**
              
              **Accumulated**
                **Other**
                **Comprehensive**
                **Income (Loss)**
              
              **Treasury**
                **Stock**
              
              **Deficit**
                **Accumulated**
                **During the**
                **Development**
                **Stage**
              
              **Total**
                **Stockholders’**
                **Equity**
                **(Deficit)**Net
                  loss
              
              
              —
              
              
              —
              
              
              —
              
              
              (10,826,392
              )
              
              (10,826,392
              )Foreign
                  currency translation adjustment
              
              
              —
              
              
              16,469
              
              
              —
              
              
              —
              
              
              16,469Comprehensive
                  loss
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (10,809,923
              )Common
                  stock issued to employee
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              273,299Fair
                  value of unearned shares related to commitment shares
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              668,969Unearned
                  common stock issued for commitment shares
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (386,091
              )Fusion
                  shares issued at various prices in 2007
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              500,000Common
                  stock issued for consulting services
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              263,500Common
                  stock issued at $0.405 per share in 2007
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              1,110,243Repurchase
                  of shares
              
              
              —
              
              
              —
              
              
              (40,100
              )
              
              —
              
              
              (40,100
              )Retirement
                  of repurchased shares
              
              
              —
              
              
              —
              
              
              40,100
              
              
              —
              
              
              —Common
                  stock issued at $0.417 per share in 2007
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              1,195,134Common
                  stock issued at $0.375 per share in 2007
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              1,250,000Amortization
                  of unearned compensation
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              85,746Fair
                  value of stock options issued in 2006 and 2007
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              237,631Balance
                  at December 31, 2007
              
              
              —
              
              
              12,088
              
              
              —
              
              
              (43,912,832
              )
              
              1,216,264Net
                  loss
              
              
              —
              
              
              —
              
              
              —
              
              
              (3,386,701
              )
              
              (3,386,701
              )Foreign
                  currency translation adjustment
              
              
              —
              
              
              28,966
              
              
              —
              
              
              —
              
              
              28,966Comprehensive
                  loss
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (3,357,735
              )Unearned
                  common stock issued for commitment shares
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              240,822Common
                  stock issued for consulting services
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              256,250Amortization
                  of unearned compensation
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              14,668Fair
                  value of stock options issued in 2006 and 2007
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              33,128Common
                  stock issued to employee
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              136,666Treasury
                  stock received in exchange for shares of subsidiary
              
              
              —
              
              
              —
              
              
              (483,000
              )
              
              —
              
              
              (483,000
              )Retirement
                  of treasury stock
              
              
              —
              
              
              —
              
              
              483,000
              
              
              —
              
              
              —Balance
                  at September 30, 2008
              
              $
              —
              
              $
              41,054
              
              $
              —
              
              $
              (47,299,533
              )
              $
              (1,942,937
              )




*See
      Notes to Consolidated Financial Statements*




F-9


**O2DIESEL
      CORPORATION**


**(A
      Development Stage Company)**




**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**




**For
      the nine months ended September 30, 2008 and 2007 and the**


**Period
      from October 14, 2000 (inception) through September 30,
      2008**


**(Unaudited)**


**October 14, 2000****(inception)****Nine Months Ended September 30**
              
              **through****2008**
              
              **2007**
              
              **September 30, 2008****Cash
                  flows from operating activites**Net
                  loss
              
              **$**
              **(3,386,701**
              **)**
              **$**
              **(7,413,639**
              **)**
              **$**
              **(47,299,533**
              **)**Adjustments
                  to reconcile loss to net cash used in operating activites:Depreciation
              
              
              58,173
              
              
              69,922
              
              
              439,549Amortization
              
              
              -
              
              
              -
              
              
              7,786Write
                  off of patent
              
              
              -
              
              
              -
              
              
              337,329Write
                  off of obsolete inventory
              
              
              -
              
              
              -
              
              
              5,925Loss
                  on sale/disposal of furniture & equipment
              
              
              30,048
              
              
              -
              
              
              40,300Loss
                  on impairment of construction in progress
              
              
              -
              
              
              -
              
              
              1,288,614Gain
                  on sale of subsidiary
              
              
              (483,000
              )
              
              -
              
              
              (483,000
              )Non
                  cash contributions
              
              
              -
              
              
              -
              
              
              5,312Common
                  stock and warrants issued for consulting services
              
              
              256,250
              
              
              240,000
              
              
              773,850Common
                  stock issued to employee
              
              
              136,666
              
              
              273,299
              
              
              409,965Common
                  stock issued for commitment shares
              
              
              240,822
              
              
              202,602
              
              
              523,700Amortization
                  of unearned compensation
              
              
              47,796
              
              
              278,992
              
              
              2,098,747Changes
                  in operating assets and liabilites:Accounts
                  receivable
              
              
              111,311
              
              
              (95,077
              )
              
              (4,225
              )Other
                  receivables
              
              
              (43,625
              )
              
              517,500
              
              
              (
                  236,244
              )Inventory,
                  prepaid expenses and other current assets
              
              
              206,867
              
              
              (177,673
              )
              
              (
                  328,509
              )Accounts
                  payable
              
              
              (437,203
              )
              
              903,656
              
              
              1,337,045Accrued
                  expenses
              
              
              (324,827
              )
              
              228,223
              
              
              232,457Deferred
                  grants
              
              
              51,331
              
              
              307,477
              
              
              527,311Deferred
                  marketing program
              
              
              (86,333
              )
              
              (166,667
              )
              
              -Cash
                  flows used in operating activities
              
              
              **(3,622,424**
              **)**
              ****
              **(4,831,385**
              **)**
              ****
              **(40,323,620**
              **)****Cash
                  flows from investing activities**Restricted
                  cash
              
              
              2,283,503
              
              
              745,877
              
              
              (50,456
              )Purchase
                  of furniture and equipment
              
              
              7,742
              
              
              (1,107,572
              )
              
              (2,046,959
              )Proceeds
                  from sale of furniture & equipment
              
              
              7,000
              
              
              -
              
              
              20,150Purchase
                  of patent
              
              
              -
              
              
              -
              
              
              (345,115
              )Cash
                  flows used in investing activities
              
              
              **2,298,246**
              ****
              ****
              **(361,695**
              **)**
              ****
              **(2,422,379**
              **)****Cash
                  flows from financing activities**Net
                  proceeds from issuance of preferred stock
              
              
              -
              
              
              -
              
              
              5,478,764Net
                  proceeds from private placement
              
              
              -
              
              
              -
              
              
              5,953,757Purchase
                  of treasury stock
              
              
              -
              
              
              (40,100
              )
              
              (40,100
              )Net
                  proceeds from issuance of note payable
              
              
              750,000
              
              
              -
              
              
              750,000Net
                  proceeds from issuance of common stock
              
              
              -
              
              
              2,805,377
              
              
              30,605,870Cash
                  flows provided by financing activities
              
              
              **750,000**
              ****
              ****
              **2,765,277**
              ****
              ****
              **42,748,291**Effect
                  of exchange rate changes on cash
              
              
              28,966
              
              
              12,799
              
              
              34,141**Net
                  increase in cash**
              
              
              **(545,212**
              **)**
              ****
              **(2,415,004**
              **)**
              ****
              **36,433**
              ********
              ****
              ****
              ****
              ****
              ****
              ****
              ****
              ****
              ****
              ******Cash
                  at beginning of period**
              ****
              ****
              **581,645**
              ****
              ****
              **3,065,630**
              ****
              ****
              **-****Cash
                  at end of period**
              
              **$**
              **36,433**
              ****
              **$**
              **650,626**
              ****
              **$**
              **36,433**Cash
                  paid for interest
              
              $
              8,767
              
              $
              8,343
              
              $
              132,280Cash
                  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.


Receipt
      of treasury stock in exchange for shares of subsidiary company in 2008,
      $483,000.




*See
      Notes to Consolidated Financial Statements*




F-10


**O2Diesel Corporation**


**(A Development
      Stage Company)**


**Notes
      to Consolidated Financial Statements**


**(Unaudited)**




**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’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.




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 Company has received approvals to list
      75,244,983 shares of the Company’s common stock so that the total number of
      shares approved for listing is now 121,763,881. Our shares began to trade on
      the
      Exchange on July 1, 2004.





On
      April 28, 2008 the Company announced that it began trading on the Pink
      Sheet Electronic Quotation Service under the trading symbol OTOD.PK. The
      Company’s shares then began to trade under the symbol OTOD.OB on or about May
      26, 2008.





O2Diesel
      was reincorporated in the state of Delaware in a transaction that became
      effective on December 31, 2004.




**Basis
      of Presentation**




The
      Company’s unaudited consolidated financial statements for the three and nine
      months ended September 30, 2008 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.  We have reclassified
      certain prior-period amounts to conform to the current period’s
      presentation.  If the Company were to continue to incur losses without
      additional funding and were to fail to continue as a going concern, then its
      assets and liabilities would be required to be stated on a liquidation basis
      which would differ significantly from the going concern basis.




At
      September 30, 2008, the Company had negative working capital of $1,458,030,
      of
      which $50,456 was restricted in use to operational costs associated with
      developing markets in Europe, and had accumulated losses of $47,299,533. 
At December 31, 2007, the Company had positive working capital of $848,207,
      of which $2,333,959 was restricted in use to operational costs associated with
      developing markets in Europe, and had accumulated losses of $43,912,832. 
The lack of adequate working capital and continuing losses create an uncertainty
      about the Company’s ability to continue as a going concern. The financial
      statements do not include any adjustments that might be necessary if the Company
      is unable to continue as a going concern.




Management
      has concluded that additional equity must be raised in 2008 in order for the
      Company to have sufficient cash to execute its business plan. If the Company
      is
      unable to timely secure additional funding, we may need to restructure or
      significantly curtail our operations, divest all or a portion of the business,
      file for bankruptcy or cease operations.




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.




From
      July 2003 through October 2008, the Company has raised approximately $37
      million for its operations.




F-11




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**





**1.
      The Company and Basis of Presentation (continued)**





**AMEX
      Delisting**




For
      the year ended 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 AMEX listing requirements. On June 29, 2007, the
      Company was notified by AMEX that it was not in compliance with the listing
      standards of the Exchange because it lacked the requisite amount of
      stockholders’ equity.  The Company was asked to submit a plan by
      July 27, 2007 advising AMEX of actions the Company would be taking to bring
      it into compliance with the continued listing standards by December 29,
      2008.




On
      July 27, 2007, the Company filed a plan with the Exchange describing the
      steps it planned to take to return to full compliance.  On
      September 13, 2007, the Company received a written notice from the AMEX
      indicating that AMEX had reviewed and accepted the Company’s plan to regain
      listing qualifications compliance.  With the acceptance of the plan, the
      Company would be able to continue its listing during the plan period pursuant
      to
      an extension granted until December 29, 2008.  The AMEX notice also
      advised the Company that, in addition to the previously disclosed deficiency
      with respect to Section 1003(a)(iii) of the AMEX Company Guide, it had
      triggered an additional deficiency with respect to
      Section 1003(a)(ii).





Under
      the
      terms of the notice from AMEX, the Company was to continue to provide AMEX
      staff
      with updates regarding initiatives set forth in its plan of compliance.  If
      the Company was not in compliance on December 29, 2008, or the Company did
      not make progress consistent with the plan during the interim period, the AMEX
      would likely initiate procedures to de-list the Company’s common stock. On
      February 7, 2008, the Company received notice from the staff of the AMEX
      that due to the deferral of the ProEco project, as described in Note 3, the
      Company was no longer demonstrating progress consistent with the plan and had
      determined to proceed with an application to the Securities and Exchange
      Commission to remove the common stock of the Company from listing and
      registration on AMEX. This action was taken because the Company is not in
      compliance with Section 1003(a)(ii) and (iii) of the AMEX Company
      Guide.




On
      February 12, 2008, the Company appealed the delisting determination by
      requesting an oral hearing to present its plan, its progress in achieving the
      plan and maintaining its AMEX listing. On April 4, 2008, the Company
      received notice from AMEX that it was not in compliance with
      Sections 1003(a)(i) and (iv) of the AMEX Company Guide. 
Subsequent to an oral hearing on April 15, 2008, the Company received
      notice on April 21, 2008 from AMEX indicating its determination to prohibit
      the continued listing of the Company’s common stock on the Exchange and to
      initiate delisting proceedings.





On
      April 28, 2008 the Company announced that it began trading on the Pink
      Sheet Electronic Quotation Service under the trading symbol OTOD.PK. The
      Company’s shares then began to trade under the symbol OTOD.OB on or about May
      26, 2008.





**2.
      Summary of Significant Accounting Policies**




**Principles
      of Consolidation**




The
      consolidated financial statements include the accounts of the Company, its
      subsidiaries and all affiliated subsidiaries. All significant inter-company
      balances and transactions have been eliminated in consolidation. Based on
      Financial Accounting Standards Board (“FASB”) Interpretation No. 46R,
“ *Consolidation of Variable Interest Entities* ”
(“FIN
      46R”), the Company was the holder of the majority of the risks and rewards
      relating to the development of a new ethanol plant to be built by ProEco Energy
      Company, Inc. (“ProEco”) until the end of the quarter ended June 30, 2008.
      As such, the Company was considered to be the “primary beneficiary” of ProEco,
      deemed to be a variable interest entity (“VIE”), and included ProEco’s assets,
      liabilities and operating results in its consolidated financial statements
      for
      the three and six months ended June 30, 2008 and for the period October 14,
      2000 (inception) through June 30, 2008. (In general, a VIE is a
      corporation, partnership, limited-liability corporation, trust or any other
      legal structure used to conduct activities or hold assets that either
      (i) has an insufficient amount of equity to carry out its principal
      activities without additional subordinated financial support; (ii) has a
      group of equity owners that are unable to make significant decisions about
      its
      activities; or (iii) has a group of equity owners that do not have the
      obligation to absorb losses or the right to receive returns generated by its
      operations. Based on these guidelines, the Company determined that ProEco was
      a
      VIE beginning with the third quarter of 2007. Prior to that period, activity
      with ProEco was not material.)





F-12


**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




**2.
      Summary of Significant Accounting Policies (continued)**




During
      the quarter ended September 30, 2008, the Company and ProEco agreed that they
      would no longer work together to develop this or any other project. As a result,
      the Company is no longer the “primary beneficiary” of ProEco and ProEco is no
      longer considered to be a VIE. Accordingly, ProEco’s assets, liabilities and
      operating results after June 30, 2008 were no longer included in the Company’s
      consolidated financial statements and the Company has classified all ProEco
      activities as discontinued operations in the consolidated statements of
      operations.





**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 September 30,
      2008, U.S. cash deposits did not exceed the federally insured limit which was
      $100,000 per financial institution. As of December 31, 2007, U.S. cash
      deposits exceeded the federally insured limit which was $100,000 per financial
      institution. During October 2008, U.S. legislation temporarily raised such
      limit
      (until December 31, 2009) to $250,000 per account.




**Restricted
      Cash**




On
      December 16, 2005, the Company completed a private placement of its common
      stock, whereby it received approximately $3.6 million which is restricted to
      operational costs associated with developing markets in Europe.  In 2008,
      the Company notified the investor in this private placement that it has
      temporarily utilized a portion of these funds for current non-European operating
      purposes.  The investor has acknowledged this temporary utilization with
      the expectation that these funds will be repaid.  The Company has used
      approximately $1.0 million of these funds (net of $159,000 in repayments)
      through November 10, 2008.  In addition to the ($159,000) and $1.0
      million (repaid) or utilized for non-European operating purposes during the
      three and nine month periods ended September 30, 2008, respectively, restricted
      funds declined by approximately $324,000 and $1.3 million for the same periods,
      net of foreign currency (losses) gains of approximately ($16,000) and $84,000
      for the same periods, as a result of marketing expenditures 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.




**Fair
      Value of Financial Instruments**




The
      carrying amounts of cash and cash equivalents, accounts receivable, other
      receivables, unbilled appropriations receivable, inventory, prepaid expenses,
      accounts payable, accrued expenses, deferred grants and deferred marketing
      program amounts approximate fair value because of their short-term
      nature.




**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.





F-13


**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




**2.
      Summary of Significant Accounting Policies (continued)**




**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,
      Equipment, Construction in Progress**  **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 to 20 years




Depreciation
      expense recorded in the accompanying Consolidated Statements of Operations
      was
      $20,713 and $64,728, respectively for the three and nine months ended September
      30, 2007, and was $16,414, $58,173 and $439,549, respectively, for the three
      and
      nine months ended September 30, 2008 and for the period October 14, 2000
      (inception) through September 30, 2008.




**Accounting
      for Impairment of Long-Lived Assets**




The
      carrying values of intangible and 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.




In
      light
      of the postponement of the Ethanol Plant project, due to unfavorable market
      conditions, the Company has re-examined the carrying value of the construction
      in progress asset. As of December 31, 2007, management had evaluated this
      project based on its assessment of the challenges to financing projects of
      this
      nature, posed by the present debt and equity markets, as well as the limited
      likelihood that a buyer will be identified for this project in the near future.
      Accordingly, the Company believed that it was prudent not to assign a value
      to
      this asset. As such, an impairment charge of $1,288,614 was warranted and this
      adjustment was recorded in December 2007. Due to the Company’s change in
      its relationship with ProEco, this amount is included in Discontinued
      Operations.




**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 an
      important 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.
      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 its
      beginning 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 September 30, 2008 and December 31, 2007, costs
      remaining to be amortized for CityHomeTM programs were recorded on the
      balance sheet as Deferred marketing program in the amount of $0 and $86,333,
      respectively. Within Selling and marketing expense, the Company
      recorded $7,677 and ($55,908) in net expenses (income) for the
      CityHomeTM initiatives, in excess of sponsorship fees, during the three and
      nine months ended September 30, 2008 and ($22,947), $63,896 and $1,166,095
      for
      the three and nine months ended September 30, 2007 period October 14, 2000
      (inception) through September 30, 2008, respectively.




F-14




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




**2.
      Summary of Significant Accounting Policies (continued)**




**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.




**Advertising
      Expenses**




Advertising
      costs are expensed as incurred. There were no advertising expenses for the
      three
      and nine months ended September 30, 2008 and 2007 and $450,000 for the period
      October 14, 2000 (inception) to September 30, 2008.




**Research
      and Development Costs**




Research
      and development costs are expensed as incurred.




**Product
      Test and Demonstration Appropriations**




The
      Company receives appropriations from governmental agencies to fund certain
      of
      its research and development efforts. The Company evaluates the conditions
      of
      each appropriation and either increases revenue, decreases expenses or reduces
      the cost of fixed assets depending upon the attributes of the underlying grant.
      Appropriations activities are not recognized until there is reasonable assurance
      that the Company will comply with the conditions of the grant and that the
      grant
      will be received.




**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.
      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**




In
      December 2004, the FASB issued SFAS No. 123 (revised
      2004), *“Share-Based
      Payment”* (“SFAS 123(R)”), which replaces FASB Statement No. 123, *“Accounting
      for Stock-Based Compensation”* (“SFAS 123”) and supersedes Accounting Principles Board (“APB”) Opinion
      No. 25 (“APB 25”). Prior to January 1, 2006, the Company’s
      share-based employee compensation plan was accounted for under the recognition
      and measurement provisions of APB 25 and related Interpretations, as
      permitted by SFAS 123. The Company did not recognize stock-based
      compensation cost in its statement of operations for periods prior to
      December 31, 2005 as all options granted had an exercise price equal to or
      higher than the market value of the underlying common stock on the date of
      grant. However, compensation expense was recognized under APB 25 for
      certain options granted to non-employees of the Company based upon the intrinsic
      value. SFAS 123(R) requires all share-based payments, including grants
      of employee stock options, to be recognized in the financial statements based
      on
      their fair values beginning with the first interim period after
      December 15, 2005, with early adoption encouraged. The pro forma
      disclosures previously permitted under SFAS 123 will no longer be an
      alternative to financial statement recognition.




Effective
      January 1, 2006, the Company adopted the fair value recognition provisions
      of SFAS 123(R) using the modified prospective transition method. As a
      result, the Company’s net loss before taxes was $2,112,040 higher for the period
      October 14, 2000 (inception) through September 30, 2008, than if it had
      continued to account for share-based compensation under
      APB 25.




Stock
      options generally vest over three years and expire ten 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 of Directors 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.  During the three and nine months ended September 30, 2008, no
      additional options were granted and 1,350,000 and 1,550,000 options expired
      unexercised, respectively. During the three and nine months ended September
      30,
      2007, no additional options were granted and 1,475,000 options expired
      unexercised.





F-15





**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




**2.
      Summary of Significant Accounting Policies (continued)**




The
      fair
      value of each option granted was estimated on the date of grant using the
      Black-Scholes option-pricing model. The assumptions used with this model were
      as
      follows:




**2007**
            
            **2006**
            
            **2005**Expected
                life
            
            
            3
                years
            
            
            3
                years
            
            
            3
                yearsDividend
                yield
            
            
            0
            %
            
            0
            %
            
            0
            %Volatility
                range*
            
            
            73
            %
            
            72–209
            %
            
            59–
                120
            %Risk-free
                interest rate*
            
            
            4.16
            %
            
            4.64–
                5.09
            %
            
            3.39–
                3.96
            %





*
      Depending on the date of grant.




**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.




In
      June,
      2006, the FASB issued Interpretation No. 48, *“Accounting
      for Uncertainty in Income Taxes”* (FIN 48) which was effective for fiscal years beginning after
      December 15, 2006. This interpretation clarified the accounting for
      uncertainty in income taxes recognized in accordance with SFAS 109.
      Specifically, FIN 48 clarifies the application of SFAS 109 by defining
      a criterion that an individual tax position must meet for any part of the
      benefit of that position to be recognized in an enterprise’s financial
      statements. Additionally, FIN 48 provides guidance on measurement,
      derecognition, classification, interest and penalties, accounting in interim
      periods of income taxes, as well as the required disclosure and transition.
      This
      interpretation was effective for fiscal years beginning after December 15,
      2006. Effective January 1, 2007, the Company adopted FIN 48 and has
      determined that such adoption has not had a significant effect on the Company’s
      consolidated financial position and results of operations.




**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 period-end 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 stockholders’ equity (deficit)
      as “accumulated other comprehensive income” and are not included in determining
      the consolidated net loss. As of September 30, 2008 and December 31, 2007,
      accumulated other comprehensive income included $41,054 and $12,088,
      respectively, of cumulative income from foreign currency
      translation.




The
      Company began operations in Brazil in March of 2004 by establishing a
      75%-owned subsidiary. The Brazilian subsidiary recognized $8,157, $8,157, $0
      and
      $0 of revenue for the three and nine months ended September 30, 2008 and 2007
      and $15,839 for the period October 14, 2000 (inception) through September
      30, 2008. Brazil also had total assets less current liabilities (exclusive
      of
      intercompany amounts eliminated in consolidation) of $69,525 and $95,201 at
      September 30, 2008 and December 31, 2007, respectively. Transactions in
      Brazil are denominated in, and the functional currency is, the Brazilian Real.
      Accordingly, no Brazilian operations currency exchange rate gains or losses
      are
      recorded in the accompanying consolidated statement of operations.




F-16




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**





**2.
      Summary of Significant Accounting Policies (Continued)**





At
      September 30, 2008 and December 31, 2007, the Brazilian operation had
      aggregate losses of $2,348,462 and $2,038,986, respectively. 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. During the third quarter of 2008, the Company reached an
      agreement with its 25% minority shareholder and two former employee shareholders
      (less than 1%) of our Brazilian subsidiary, in which these shareholders agreed
      to relinquish their shares to the Company in return for a general release of
      obligations to the subsidiary. The transaction was finalized in an agreement
      dated September 17, 2008. The change in shareholders had no impact on our
      financial statement presentation.





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.
      Since that date, these subsidiaries incurred no activity and therefore had
      no
      profit or loss.




The
      company began operations in Spain in April of 2006 by establishing a 100%
      subsidiary. The Spanish subsidiary recognized $6,799 of revenue for the
      three and nine months ended September 30, 2007 and $470, $4,897, and $17,073
      of revenue for the three and nine months ended September 30, 2008 and for
      the period of April 2006 through September 30, 2008, respectively. At
      September 30, 2008 and December 31, 2007, the Spanish subsidiary had total
      assets less current liabilities (exclusive of intercompany amounts eliminated
      in
      consolidation) of $104,656 and $275,678, respectively. Transactions in Spain
      are
      denominated in, and the functional currency is, the Euro. At September 30,
      2008
      and December 31, 2007, the Spanish operation had aggregate losses of
      $3,024,133 and $1,933,878, respectively.




The
      Company expanded its operations in Ireland in August 2007 by establishing a
      100% owned subsidiary. At September 30, 2008, this subsidiary did not have
      active operations.




**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
      September 30, 2008 and December 31, 2007 and the results of operations and
      cash flows presented herein for the three and nine month periods ended September
      30, 2008 and 2007 and from inception (October 14, 2000) through September
      30, 2008 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, 2008. 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, 2007 previously
      filed with the Securities and Exchange Commission (the "SEC") on March 31,
      2008 and the Form 10-KSB/A Amendment No. 2 previously filed with the SEC on
      September 24, 2008.




F-17


**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




**3.
      ProEco Transaction**




On
      January 12, 2007, the Company entered into a Share Exchange Agreement (the
“Agreement”) with 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, had been in the process of developing
      a new fuel-grade Ethanol Plant with planned capacity of at least
      100 million gallons per year to be built in two 50 million gallon
      stages (each a “Train”). Pursuant to the terms of the Agreement, ProEco
      Shareholders would receive 60% of the Transaction Shares at the time of the
      closing and would 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 would be held in escrow until the conditions for
      their
      release had been met. The parties intended 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 “Code”).





The
      Agreement required 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 was required to 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
      corn
      feedstock as well as the sale of the production of the Ethanol Plant. Pursuant
      to the terms of the Agreement, ProEco was 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 was obligated
      to secure the financing necessary to complete the construction costs to build
      the Ethanol Plant. Accordingly, the Company was required to raise $60 to
      $70 million in debt and between $30 and $40 million in equity in the
      first quarter of 2008 for each train.




Prior
      to
      closing, the Company and the ProEco Shareholders were to enter into a
      stockholder agreement that would, among other things, impose restrictions on
      the
      transfer of the Transaction Shares.




The
      Common Stock was to be issued to the ProEco Shareholders in a transaction that
      would 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.




Pursuant
      to the terms of the letter of intent for the 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 annual interest rate on the loan is 7% and the maturity date
      of
      the loan was December 15, 2007.




Current
      trends in the ethanol industry have seen increases in the price of corn and
      other feedstocks as well as a decline in the average selling price of ethanol.
      For a number of new plant construction projects, the lack of EPC contractor
      availability has resulted in increased costs and delays in completion dates.
      On
      January 8, 2008, the Company announced that due to the unfavorable market
      conditions for raising capital for ethanol plants, the Company and ProEco had
      entered into an agreement to extend the Share Exchange Agreement and the
      maturity date of the loan from the Company to ProEco until January 31,
      2008. These agreements were subsequently extended again until February 29,
      2008. On March 19, 2008, the Company and ProEco entered into a letter
      agreement terminating the Share Exchange Agreement and extending the maturity
      date of the loan from February 29, 2008 until November 30, 2008. The
      Company and ProEco agreed to continue to develop the Ethanol Plant when
      conditions in the capital markets improve.





At
      December 31, 2007, management had evaluated this project based on its
      assessment of the challenges to financing projects of this nature, posed by
      the
      existing debt and equity markets, as well as the limited likelihood that a
      buyer
      would be identified for this project in the near future. Accordingly, the
      Company believed that it was prudent not to assign a value to this asset. As
      such, an impairment charge of $1,288,614 was warranted and this adjustment
      was
      recorded in December 2007.




F-18




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




**3.
      ProEco Transaction (continued)**





Based
      on
      FIN 46R, the Company was the holder of the majority of the risks and
      rewards relating to ProEco as of the period ended June 30, 2008. As such, the
      Company was considered to be the “primary beneficiary” of ProEco which was
      deemed to be a VIE. (In general, a VIE is a corporation, partnership,
      limited-liability corporation, trust or any other legal structure used to
      conduct activities or hold assets that either (i) has an insufficient
      amount of equity to carry out its principal activities without additional
      subordinated financial support; (ii) has a group of equity owners that are
      unable to make significant decisions about its activities; or (iii) has a
      group of equity owners that do not have the obligation to absorb losses or
      the
      right to receive returns generated by its operations.) Based on these
      guidelines, the Company determined that ProEco was a VIE beginning with the
      third quarter of 2007 and has included ProEco’s assets, liabilities and
      operating results in its consolidated financial statements for all subsequent
      periods through June 30, 2008. Prior to the third quarter of 2007, activity
      with
      ProEco was not material.





During
      the period ended June 30, 2008, the Company devoted no significant activity
      to
      the ProEco transaction. ProEco retained the documentation developed to implement
      the proposed project and had secured its option rights to the land at the site
      until October 15, 2008 through an agreement with the Belle Fourche Development
      Corporation in South Dakota. Both the Company and ProEco continued to monitor
      market conditions for the development and financing of ethanol plants during
      2008. However, no opportunities for such a project have been pursued. The
      Company agreed with ProEco to release the land option in the event an
      alternative project for the property were to become available. It is the
      Company’s understanding that the land option expired unexecuted. The Company is
      no longer working with ProEco on this or any other project, which effectively
      terminates the VIE relationship. Accordingly, ProEco’s assets, liabilities and
      operating results after June 30, 2008 were treated as a discontinued operation
      and no longer included in the Company’s consolidated financial statements. A
      summary of the results of this discontinued operation is as
      follows:




**October 14, 2000****(inception)****Three Months**
            
            **Nine Months**
            
            **through****9/30/2008**
            
            **9/30/2007**
            
            **9/30/2008**
            
            **9/30/2007**
            
            **September 30, 2008**Loss
                from ProEco operations
            
            $
            -
            
            $
            (327,216
            )
            $
            (17,258
            )
            $
            (327,216
            )
            $
            (417,931
            )Loss
                on impairment of construction in progress
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (1,288,614
            )Gain
                on disposal of ProEco operations
            
            
            89,287
            
            
            -
            
            
            89,287
            
            
            -
            
            
            89,287Loss
                from Discontinued Operations
            
            $
            89,287
            
            $
            (327,216
            )
            $
            72,029
            
            $
            (327,216
            )
            $
            (1,617,258
            )





The
      significant assets and liabilities of ProEco as of December 31, 2007 were
      cash ($8,310), accounts payable ($351,005) and accrued expenses
      ($31,304).





**4.
      Common Stock and Warrant Activity During 2008**




**Energenics
      Transactions**




On
      October 17, 2007, the Company announced that it had entered into a private
      financing agreement and a joint venture transaction with Energenics Holdings
      Pte
      Ltd (“Energenics”) to provide funding and commercial support for the development
      of the Asian market. At that time, the parties entered into a Common Stock
      and
      Warrant Purchase Agreement (the “ *Agreement* ”)
      pursuant to which Energenics agreed to purchase 2,551,020 shares of the
      Company’s common stock in a private placement, for total proceeds of
      approximately $1.25 million. As part of the transaction, the Company agreed
      to
      issue a warrant to purchase 1,275,510 shares of common stock at an exercise
      price of $0.50 per share, which warrant would be issued upon the closing of
      the
      transactions contemplated by the Agreement and would become exercisable from
      the
      date that is six months following the date of issuance until October 17, 2012
      (“ *Investment Warrant* ”).




F-19


**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**





**4.
      Common Stock and Warrant Activity During 2008 (Continued)**





The
      parties also entered into a Shareholders Agreement, in which Energenics and
      the
      Company would jointly develop the market for O2DieselTM in Asia through O2Diesel
      Asia Limited (“O2Diesel Asia”). Energenics agreed to pay the Company $750,000
      for a fifty percent (50%) equity interest in O2Diesel Asia. The balance of
      the
      interest in O2Diesel Asia was to be held by O2Diesel Europe Limited, a
      wholly-owned subsidiary of the Company. Pursuant to the Supply and Distribution
      Agreement, dated September 15, 2006 (“ *Supply Agreement”* ),
      O2Diesel has supplied its additive to Energenics for the manufacture and
      distribution of O2DieselTM in the Asian Pacific and South Asia.





The
      parties also were to enter into a License agreement(“ *O2Diesel
      Asia License Agreement* ”),
      whereby O2Diesel Europe Limited (formerly AAE Technologies International Plc)
      would license to O2Diesel Asia certain patents and know-how that are required
      to
      make and sell O2DieselTM in the Territory in exchange for certain payments
      pursuant to the Shareholders Agreement. In addition, the Company was to enter
      into a similar License agreement (the “ *License Agreement* ”
and
      together with the O2Diesel Asia License Agreement, the “ *Licenses* ”),
      with
      O2Diesel Asia, pursuant to which the Company would pay to O2Diesel Asia a
      royalty based on sales of the Company’s product in the Territory.





As
      part
      of the transaction, upon the purchase of a certain quantity of O2D05 or the
      equivalent, the Company would also issue a warrant to purchase 1,500,000 shares
      of common stock at an exercise price of $0.50 per share, which warrant would
      be
      exercisable during the period from the date of issuance until October 17,
      2012 (“ *JV
      Warrant”)* .





Also,
      as
      part of the transaction, upon the achievement by Energenics of certain levels
      of
      additional purchases of O2D05 or the equivalent, the Company was to issue
      additional warrants to purchase up to an aggregate of 6,500,000 shares of common
      stock at a price per share equal to the lesser of $0.50 or 106% of the closing
      price per share (rounded to the nearest cent) of the Company’s common stock on
      the American Stock Exchange on the date such warrants are earned (“ *Market Development Warrants* ,” and,
      collectively with the Investment Warrant and the JV Warrant, the “ *Warrants* ”).
      The
      Market Development Warrants were to be exercisable from the date of issuance
      to
      October 17, 2012.





On
      December 10, 2007, the Company and Energenics entered into an amendment (the
      “ *Amendment* ”)
      to the
      Common Stock and Warrant Purchase Agreement, dated October 17, 2007. Pursuant
      to
      the Amendment, the Company agreed to increase the number of shares of common
      stock by 782,313 shares to 3,333,333 shares, which reduced the per share price
      from $0.49 to $0.375. The per share price of $0.375 represented 121% of the
      current market price on the American Stock Exchange the day prior to the signing
      of the Amendment. In addition, the Company agreed to issue an additional 391,157
      shares exercisable pursuant to the warrant associated with the Investment
      Warrant. In addition, the Company was to issue additional warrants (the
“ *Additional
      Warrants* ,”
and
      collectively, with the Investment Warrant, the Market Development Warrants
      and
      the JV Warrant, (the “ *Warrants* ”)
      to
      purchase shares of common stock, upon the purchase of certain quantities of
      O2D05 or the equivalent. Pursuant to the Amendment, the exercise price per
      share
      for the shares associated with these Additional Warrants was also reduced to
      $0.375.




All
      other
      terms and conditions of the transaction remain as provided in the
      Agreement.





The
      common stock and the Warrants were to be issued to the accredited investor
      in a
      transaction that would be exempt from registration pursuant to Section 4(2)
      of
      the Securities Act of 1933, as amended (the “Securities Act”), and/or Regulation
      D promulgated under the Securities Act. On June 17, 2008, the Company entered
      into an Amending and Restating Agreement with Energenics to reflect the
      renegotiated terms of previously announced agreements to provide $2,000,000
      of
      funding and commercial support to develop the Asian market for O2DieselTM, the
      Company’s ethanol diesel fuel blend.





A ccording
      to the terms of the Amending and Restating Agreement, the original Common Stock
      and Warrant Purchase Agreement dated October 17, 2007, and the subsequent
      Amendment are to be terminated and the 3,333,333 previously issued shares of
      O2Diesel Corporation common stock are to be returned to the Company and retired
      by the Company. In exchange for these shares Energenics acquired an eighty
      percent (80%) equity interest in O2Diesel Asia. This transaction was accounted
      for based on the fair value of the Company’s stock received as of the date of
      the amended agreements, June 17, 2008. These shares were then retired. The
      balance of the interest in O2Diesel Asia is to be held by O2Diesel Europe
      Limited, a wholly-owned subsidiary of the Company. The existing Warrants (as
      amended), Licenses and Supply Agreement will remain unchanged. At September
      30,
      2008, this subsidiary did not have active operations.





On
      June
      17, 2008, and as part of the amended agreements, the Company issued to
      Energenics an unsecured, Convertible Promissory Note for the principal sum
      of
      $750,000. The term of the note is for thirty-six months from the date the Note
      was issued and accrues interest at the rate of 5% per year. Energenics may,
      at
      its option, convert all or part of the principal and interest outstanding on
      this note at a conversion price of $0.145 per share .




F-20




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**





**4.
      Common Stock and Warrant Activity During 2008 (continued)**





The
      Company received $1,250,000 in two deposits on November 14, 2007 and December
      21, 2007 to be applied toward the equity portion of the transaction and $750,000
      in three deposits on July 10, 2008, August 11, 2008 and September 5, 2008 to
      be
      applied toward the Promissory Note. Upon payment of the required Irish stamp
      tax
      associated with the transfer of the O2Diesel Asia shares, the transaction will
      close. The Company anticipates this closing to take place during the fourth
      quarter of 2008.





**KL
      Process Transaction**




On
      March 11, 2008, the Company’s wholly-owned subsidiary O2Diesel Europe, Plc
      (“O2Diesel Europe”) entered into an exclusive Technology License and Services
      Agreement (the “KL Agreement”) with KL Process Design Group, LLC (“KL”) whereby
      O2Diesel Europe obtained an exclusive license to use, exploit and sublicense
      certain KL intellectual property, know-how and processes for the production
      and
      sale of ethanol from feedstocks other than simple sugars and starches (the
      “Product”).  KL granted this license to O2Diesel Europe on an exclusive
      basis in Europe, India, Russia and other rapidly developing global
      markets.  Pursuant to the Agreement, KL also agreed to provide certain
      services related to the design and construction of production plants necessary
      to produce the Product.




As
      part
      of the KL Agreement, the Company agreed to issue 1,000,000 shares of the
      Company’s common stock to KL as consideration for the license as well as certain
      royalty and design services fees.  The stock is to be issued upon
      commencement of the first project under the KL Agreement or 18 months after
      the
      effective date of the KL Agreement, whichever is earlier. The common stock
      will
      be 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.





On
      September 30, 2008, KL Energy Corporation (“KLE”, formerly known as Revive-It
      Corp.) entered into an Agreement and Plan of Merger with KL which provides
      for
      the merger of KL with and into KLE, and accordingly, KLE and KL filed the
      Articles of Merger with the State of Nevada effecting the merger. All of the
      outstanding membership interests of KL were converted into newly issued shares
      of common stock of KLE, which were issued to the former members of KL. As a
      result of the merger, KL merged with and into KLE, with KLE as the surviving
      corporation. As a result of the merger, KLE succeeded to, and acquired all
      of,
      the assets and liabilities of KL, including all of the contractual rights and
      interests of KL. For accounting purposes, the merger was treated as a reverse
      acquisition with KL as the acquirer and KLE as the acquired party. On September
      8, 2008 KLE began trading on the Pink Sheet Electronic Quotation Service under
      the trading symbol KLEG.OB.





**5.
      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, continued until June 30, 2007. As of September 30, 2008, NREL had
      not
      yet closed this contract. 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 September 30, 2008 and
      December 31, 2007, the Company had incurred the full cumulative costs of
      $2,039,651 towards completion of the contract resulting in no balance of costs
      left to spend in order to complete the contract. From the inception of the
      contract in December 2002 through September 30, 2008 and December 31, 2007,
      the Company billed NREL $1,631,720 of which $16,317 is included in other
      receivables as of September 30, 2008 and December 31, 2007.





F-21




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




**5.
      Government Appropriations (continued)**





**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 California Air Resources Board (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. During the third quarter of 2008, funds
      generated by the appropriations described in Department of Energy (3) were
      amended into this contract for a total contract amount of $2,098,834. Additional
      testing tasks were added to the statement of work as well as a demonstration
      of
      savings in maintenance costs. The contract period has been extended through
      2009. As of September 30, 2008 and December 31, 2007, the Company had incurred
      cumulative costs of $1,084,241 and $986,222, respectively, towards completion
      of
      the contract, leaving a balance of $1,021,647 and $137,612, respectively, in
      costs to complete the contract. From the inception of the contract through
      September 30, 2008 and December 31, 2007, the Company billed NREL $861,749
      and
      $786,847, respectively, of which $10,861 and $57,690 is included in other
      receivables as of September 30, 2008 and December 31, 2007,
      respectively.





**Appropriation
      from the U.S. Department of Energy (3)**





During
      2004 and 2005, the Company received $1,000,000 in available appropriations
      for
      the purpose of continued testing and verification of our fuel additive. The
      Company amended the contract described in Department of Energy (2) to include
      funds for the test projects contained in a proposal previously submitted for
      Department of Energy (3).





**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 (“DoD”) 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 was not 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 DoD as is permitted under that contract. However, the funds
      from Appropriation (1) cannot be applied to Appropriation (2). Through
      December 31, 2005, the Company had received cash in excess of costs incurred
      of
      $296,097 and had 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 DoD. Under this contract, the Company's O2Diesel TM 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
      O2Diesel TM as a
      viable alternative fuel for use by the Air Force. Work on this contract
      commenced on November 1, 2004 and continued 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 DoD 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. As of December 31, 2006, costs totaling $1,011,215 had been
      incurred and billed, leaving a remaining contract balance of $1,349. As of
      December 31, 2007, this contract was formally closed.




F-22




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**





**5.
      Government Appropriations (continued)**





**Appropriation
      from the U.S. Department of Defense (3)**





The
      Company received an appropriation during 2005 of approximately $910,000 from
      the
      DoD. Concurrent Technologies Corporation (CTC) manages this appropriation on
      behalf of the DoD. This contract contains a payment schedule based on meeting
      performance milestones. Four milestones were achieved during 2006 which resulted
      in issuing $530,000 of invoices during 2006. The primary objective of this
      contract is to create potential fuels using the Company additive that contains
      no more than 80% petroleum. If this project is successful, an application will
      be made to DOE 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 and Minot Air Force Base in North
      Dakota. As of September 30, 2008 and December 31, 2007, $910,000 and $860,576
      in
      expenses had been incurred, leaving an available contract balance of $0 and
      $49,424, respectively. In addition to the $910,000 and $715,000 in expenses
      that
      had been invoiced as of September 30, 2008 and December 31, 2007, based on
      achieving all the contract milestones through those dates, the Company has
      recorded Unbilled Appropriations of $0 and $145,576 at September 30, 2008 and
      December 31, 2007, respectively, in the consolidated balance sheets. The
      Company will begin closing out this contract.




**Appropriation
      from the U.S. Department of Defense (4)**




In
      2005,
      the Company received an appropriation of approximately $1,100,000 for continued
      testing and verification of O2Diesel TM . The
      Company entered into a contract for $575,000 in 2007. As of September 30, 2008,
      lab testing of a new fuel combining O2Diesel TM ,
      biodiesel, and diesel had been conducted and field-testing was completed at
      Nellis Air Force Base in Las Vegas, Nevada and at Barksdale Air Force Base
      in
      Shreveport, Louisiana.




**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. Of this amount, $688,710 was added during
      the third quarter of 2007 to the contract described in DoD (4), for a total
      contract amount of $1,263,710 at December 31, 2007. This contract was further
      amended during the second quarter of 2008 to delete several tasks and replace
      them which caused a net reduction of $67,224 from the total amount, resulting
      in
      a revised total contract amount of $1,196,486 at September 30, 2008. These
      funds
      will be used by CTC to conduct lab testing on behalf of this project. The
      contract with CTC contains a payment schedule based on meeting performance
      milestones. Twelve and six milestones were achieved which resulted in the
      issuance of invoices totaling $924,700 and $620,536 as of September 30, 2008
      and
      December 31, 2007, respectively. Aggregate costs of $397,389 and $144,556 were
      incurred under this contract resulting in the balance of $527,311 and $475,980
      being recorded in deferred grants in the consolidated balance sheets at
      September 30, 2008 and December 31, 2007, respectively.




**Appropriation
      from the U.S. Department of Defense (6)**




In
      2007,
      the Company received an appropriation of approximately $1,600,000 for continued
      testing and verification of O2Diesel TM . The
      Company has submitted its proposal for several possible test projects and is
      working with the Air Force to put this under a contract for approximately
      $1,188,000 in the fourth quarter of 2008.




**6.
      Other Receivables**




Significant
      components of the Company’s Other Receivables at September 30, 2008 and
      December 31, 2007 are as follows:





September 30,
            
            December 31,2008
            
            2007NREL
                contract (DOE)
            
            $
            27,178
            
            $
            74,007CTC
                contract (DoD)
            
            
            35,613
            
            
            -Receivables
                related to product demonstrations (Spain)
            
            
            35,899
            
            
            45,407VAT
                receivables (Spain)
            
            
            57,946
            
            
            57,594Other
            
            
            79,608
            
            
            15,611$
            236,244
            
            $
            192,619





F-23




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**





**7.
      Accrued Expenses**




Significant
      components of the Company’s Accrued Expenses at September 30, 2008 and
      December 31, 2007 are as follows:





September 30,
            
            December 31,2008
            
            2007Legal
                and professional fees
            
            $
            42,853
            
            $
            234,721Payroll-related
                liabilities
            
            
            80,333
            
            
            30,304Severance
                payments
            
            
            52,083
            
            
            190,508Other
            
            
            68,346
            
            
            112,909$
            243,615
            
            $
            568,442





**8.
      Income Taxes**


Federal
        and state income taxes have generally not been recorded during the periods
        presented due to the Company’s significant operating losses. The income tax
        expense provision, for the three and nine months ended September 30, 2008,
        and
        the income tax benefit, for the period of October 14, 2000 (inception) to
        September 30, 2008, reflected in the accompanying consolidated statements
        of
        operations relate to taxable transactions in Ireland.


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 September 30, 2008 and December 31,
      2007 are as follows:




September 30,
              2008
            
            December 31,
              2007Net operating
                loss carryforwards
            
            $
            13,400,127
            
            $
            11,831,969Deferred
                revenue
            
            
            (42,197
            )
            
            453,020Accrued
                expenses
            
            
            208,830
            
            
            255,818Total
                deferred tax assets
            
            
            13,566,760
            
            
            12,540,807Valuation
                allowance
            
            
            (13,566,760
            )
            
            (12,540,807
            )Net
                deferred tax assets
            
            $
            -
            
            $
            -




Management
      has determined that a valuation allowance equal to 100% of the existing deferred
      tax asset is appropriate given the uncertainty regarding the ultimate
      realization of these assets. At September 30, 2008, the Company had Federal
      and
      state net operating loss carryforwards of approximately $30.8 million for
      income tax purposes. If not used, these carryforwards begin to expire in 2021.
      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 a
      result, certain amounts of the net operating loss carryforwards may expire
      without being utilized. As of September 30, 2008, the Company had a
      cumulative Spanish loss of approximately $2.7 million and a Brazilian net
      operating loss of approximately $2.0 million that may be carried forward
      indefinitely, but which is subject to annual usage limitations.




In
      July 2006, the 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.




F-24


**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**





**8.
      Income Taxes (continued)**




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, 2004 to December 31, 2007) and for the tax years which
      remain open for examination in Ireland (December 31, 2007), Spain
      (December 31, 2007) and Brazil (December 31, 2007). Based on this
      evaluation, no reserves for uncertain income tax positions have been recorded
      pursuant to FIN 48 during the period ended September 30, 2008 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 September 30, 2008, 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. Since the adoption of FIN 48, no interest or penalties have been
      recorded relating to the settlement of tax audits.




Federal
      tax rules under Section 382 of the Code impose limitations on the
      use of net operating losses (“NOL”) 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. In general, an ownership change, as defined by
      Section 382, results from transactions increasing the ownership of certain
      shareholders or public groups in the stock of a corporation by more than 50
      percentage points over a three-year period. Since the Company’s formation, the
      Company has raised capital through the issuance of capital stock on several
      occasions which, combined with the purchasing shareholders’ subsequent
      disposition of those shares, may have resulted in a change of control, as
      defined by Section 382, or could result in a change of control in the
      future upon subsequent disposition. The Company has not currently completed
      a
      study to assess whether a change of control has occurred or whether there have
      been multiple changes of control since the Company’s formation due to the
      significant complexity and cost associated with such study and that there could
      be additional changes in control in the future. If we have experienced a change
      of control at any time since the Company’s formation, utilization of our NOL
      carryforwards would be subject to an annual limitation under Section 382.
      Any limitation may result in the expiration of a portion of the NOL
      carryforwards before utilization. Further, until a study is completed and any
      limitation is known, no amounts are being presented as an uncertain tax position
      under FIN 48.




**9.
      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.





F-25





**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




**9.
      Stockholders’ Equity (continued)**




**Common
      Stock and Warrant Activity**




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 additional 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 $1,535,570, 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. 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.




On
      July 17, 2007, the Company repurchased 100,000 shares of its common stock
      for treasury for an aggregate purchase price of $40,100. The purchase price
      was
      $0.401 per share, which was the daily volume weighted average for the five
      trading days prior to the day the Company’s board of directors approved the
      repurchase.  In December 2007, management decided to retire these
      shares.




**$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 $10.0 million
      of the Company’s common stock to Fusion Capital from time to time over a
      twenty-five 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. 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.




Concurrent
      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 filed a
      registration statement with the SEC covering the shares that have been issued
      or
      may be issued to Fusion Capital under the Purchase Agreement. Subject to earlier
      termination at the Company’s discretion, Fusion Capital’s purchases commenced
      after June 8, 2007 when the SEC declared effective the registration
      statement related to the transaction. Generally, the Company has the right
      but not the obligation from time to time to sell an aggregate of up to 12
      million 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.




During
      the three and nine months ended September 30, 2008, the Company did not execute
      any transactions under this agreement.  During the three months ended June
      30, 2007, the only period during which transactions have occurred since the
      effective date of this agreement, the Company executed five separate
      transactions, selling a total of 970,994 shares of common stock at an average
      price of $0.515 per share for total proceeds of $500,000.




F-26




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




**9.
      Stockholders’ Equity (continued)**




**$2.52
      Million Private Placement**




Between
      June 26, 2007 and July 16, 2007, the Company entered into Agreements
      with five European institutional and private investors for the sale of 6,123,346
      shares of the Company’s common stock at a purchase price of approximately $0.41
      per share in a private placement, for total proceeds of $2,517,710 before
      commissions. As a condition to the enforceability of these agreements against
      the Company, the investors were required to fund the purchase price in an escrow
      account, which funds were received between June 19, 2007 and July 31,
      2007. As part of the sale, the Company issued warrants to purchase 1,530,827
      shares of common stock at an exercise price of $0.62 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
      Company was obligated to file a registration statement with the SEC including
      the common stock and the shares issuable upon exercise of the warrants within
      90
      days of the closing date. A Form S-3 registration statement, including
      these shares and shares issuable upon exercise of the warrants, was filed by
      the
      Company on October 18, 2007 and declared effective by the SEC on
      October 31, 2007. All the costs and expenses incurred in connection with
      the registration of the common stock and warrants are paid by the Company.
      The
      Company closed this transaction on July 20, 2007 and August 20,
      2007.




**Issuances
      of Preferred Stock**




In
      March 2004, the Company approved the designation of two new series of
      preferred shares. The new preferred shares, which consist of one million five
      hundred and fifty thousand (1,550,000) shares of Preferred Stock, are
      Series A and B 0% Convertible Preferred Stock, par value $.0001 (the
“Series A Preferred Stock” and “Series B Preferred Stock”). Subsequent
      to approving the new Series A and Series B Preferred Stock, the
      Company immediately completed a transaction with a publicly traded investment
      trust on the London Stock Exchange in which it received approximately
      $2.8 million, net of all expenses, in exchange for all of the 800,000
      shares of its Series A Preferred Stock. Effective March 29, 2004, the
      Company completed a second transaction with another publicly traded investment
      trust on the London Stock Exchange in which it received approximately
      $2.1 million in May 2004, net of all expenses, in exchange for 600,000
      shares of its Series B Preferred Stock. As part of the Series B
      transaction, the remaining 150,000 shares of Series B Preferred Stock were
      released from escrow to the same publicly traded investment trust, for which
      the
      Company received approximately $536,000, net of all expenses.




The
      Series A and B Preferred Stock do not pay dividends and shall have no
      voting power, except as may be provided by state law. The stated value of both
      the Series A and B Preferred Stock is $10.00 per share (“Stated Value”),
      and the liquidation preference with respect to a share of the Series A and
      B Preferred Stock shall be its Stated Value. The Series A and B Preferred
      Stock shall, as to redemptions and distribution of assets, dissolution, or
      winding up of the Company, rank (i) prior to any class of the Company’s
      common stock, (ii) prior to any class or series of capital stock hereafter
      created that, by its terms, ranks junior to the Series A and B preferred
      Stock, (iii) junior to any class or series of capital stock of the Company
      hereafter created which by its terms ranks senior to the Series A and B
      preferred stock. The Series A and B Preferred Stock shall rank pari passu
      as to one another.




The
      Series A and B Preferred Stock may be converted at the option of the holder
      at any time following two years from the Closing dates for the purchases of
      the
      preferred shares, which were March 3, 2004 and March 29, 2004,
      respectively. Except as specified in the Certificates of Designation, neither
      the holders of the Series A and Series B Preferred Stock nor the
      Company may demand that the preferred shares be redeemed. In the event that
      the
      Company engages in a transaction or a series of transactions that cause it
      to
      consolidate or merge with or into another entity, or permit any other entity
      to
      consolidate or merge with or into it, or undergo a change in control, the
      Company may demand that the holders convert all shares of the Series A and
      B Preferred Stock into shares of the Company’s common stock. If the holders do
      not comply with such demand, the Company may redeem all shares of the
      Series A and B Preferred Stock at the Stated Value of each.




Each
      share of Series A Preferred Stock is convertible into shares of the
      Company’s common stock, at a variable conversion ratio which is the lesser of
      (a) $4.00 as adjusted (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 twenty-five percent (25.0%) of the Series A Fixed
      Conversion Price, as adjusted, or $1.00 per share. Based on the conversion
      ratio
      the holder of Series A Preferred Stock will never 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-27




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




**9.
      Stockholders’ Equity (continued)**





Each
      share of Series B Preferred Stock is convertible into shares of the
      Company’s common stock, at a variable conversion ratio which is the lesser of
      (a) $3.65 as adjusted (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 twenty-seven and four tenths percent (27.4%) of the
      Series B Fixed Conversion Price, as adjusted, or $1.00 per share. Based on
      the conversion ratio the holder of Series B Preferred Stock will never
      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
      purchaser of the Series A Preferred Stock 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.


The
      purchaser of the Series B Preferred Stock 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.




The
      Company determined that the intrinsic value of the beneficial conversion
      features embedded in the Series A and Series B Preferred Stock
      exceeded the proceeds from these Preferred Stock issuances. The Company accreted
      the value of the beneficial conversion feature through equity and recorded
      a
      deemed dividend to preferred stockholders. These dividends amounted to $0 for
      the three and six months ended September 30, 2008 and 2007 and $6,200,005 for
      the period from October 14, 2000 (inception) through September 30, 2008,
      respectively, and are included in the consolidated statements of operations.
      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 and
      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. If all
      eligible warrant holders were to exercise their warrants at the reduced price,
      the Company would receive proceeds of approximately $4.3 million. The warrant
      offer was originally set to expire on May 25, 2007, however 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. The offer
      expired on June 8, 2007, without any of the warrant holders exercising at
      the reduced price.





F-28


**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**





**9.
      Stockholders’ Equity (continued)**





**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 Incentive
      Plan.




**Weighted Ave****Weighted Ave**
            
            **Remaining****Shares**
            
            **Exercise Price**
            
            **Contractual Term**Outstanding
                at January 1, 2004
            
            
            500,000
            
            $
            1.50
            
            
            -Granted
                in 2005
            
            
            5,450,000
            
            $
            1.50
            
            
            7.1Exercised
                in 2005
            
            
            -Forfeited
                or Expired
            
            
            -Outstanding
                at December 31, 2005
            
            
            5,950,000
            
            $
            1.50
            
            
            7.1Granted
                During the Year Ended December 31, 2006
            
            
            1,350,000
            
            $
            1.28
            
            
            7.8200,000
            
            $
            1.50
            
            
            7.8100,000
            
            $
            0.71
            
            
            8.2Exercised
                During the Year Ended December 31, 2006
            
            
            -Forfeited
                or Expired
            
            
            (100,000
            )
            $
            1.28Outstanding
                at December 31, 2006
            
            
            7,500,000
            
            $
            1.43
            
            
            7.1Granted
                During the Year Ended December 31, 2007
            
            
            250,000
            
            $
            1.50
            
            
            9.3Exercised
                During the Year Ended December 31, 2007
            
            
            -Forfeited
                or Expired
            
            
            (1,575,000
            )
            $
            1.48Outstanding
                at December 31, 2007
            
            
            6,175,000
            
            $
            1.45
            
            
            7.3Granted
                During the Nine Months Ended September 30, 2008
            
            
            -Exercised
                During the Nine Months Ended September 30, 2008
            
            
            -Forfeited
                or Expired
            
            
            (1,550,000
            )
            $
            1.47Outstanding
                at September 30, 2008
            
            
            4,625,000
            
            $
            1.44
            
            
            7.3Exercisable
                at September 30, 2008
            
            
            4,542,500
            
            $
            1.45
            
            
            7.2




**Restricted
      Stock Awards**




On
      November 4, 2004, the Company entered into an investor relations consulting
      agreement for a term of four years. In exchange for services, the Company
      awarded the consultant 50,000 shares of restricted stock as settlement of this
      agreement, effective November 9, 2007 and recognized $23,500 of consulting
      expense in the third quarter of 2007.




On
      September 20, 2005, the Company entered into an investor relations
      consulting agreement for a term of one year which the parties subsequently
      agreed to renew on an annual basis. In exchange for services, the Company paid
      the consultant $7,250 per month. In addition, the Company awarded the consultant
      100,000 shares of restricted stock. As of September 30, 2008, the restrictions
      on all 100,000 shares issued under this contract had lapsed and such shares
      were
      earned and able to be sold.  On March 31, 2008, the Company awarded
      120,000 shares of restricted stock as final payment for services rendered and
      terminated this agreement. The $36,238 of expense related to this award was
      offset entirely by the settlement of amounts previously accrued for such
      services.  For the three and nine months ended September 30, 2008 and 2007
      and for the period October 14, 2000 (inception) through September 30, 2008,
      the Company recognized $0, $0, $0, $0 and $81,500, respectively, of net expense
      in connection with these stock awards.




F-29




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




**9.
      Stockholders’ Equity (continued)**




On
      November 16, 2006, the Board of Directors approved the grant of 500,000
      shares of restricted stock to a former officer, 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. Under the terms of the agreement, the receipt of shares
      was contingent on Mr. Roger remaining employed by the Company on the
      vesting date. In 2006, there was no FAS 123(R) expense for the grant
      of restricted stock.




On
      May 14, 2007, the Company entered into an investor relations consulting
      agreement for a term of two months. In exchange for services, the Company paid
      the consultant a fee of $10,000. In addition, the Company awarded the consultant
      50,000 shares of restricted stock. In connection with the stock award, the
      Company recognized $0, $0, $0, $27,000 and $27,000 of consulting expense for
      the
      three and nine months ended September 30, 2008 and 2007 and for the period
      October 14, 2000, (inception) through September 30, 2008,
      respectively.




On
      May 16, 2007, the Company entered into a second investor relations
      consulting agreement for a term of six months. In exchange for services, the
      Company awarded the consultant 440,000 shares of restricted stock. In connection
      with the stock award, the Company recognized $0, $0, $0, $213,000 and $213,000
      of consulting expense for the three and nine months ended September 30, 2008
      and
      2007 and for the period October 14, 2000, (inception) through September 30,
      2008, respectively. Pursuant to the terms of the consulting agreement, 220,000
      shares, 120,000 shares and 100,000 shares of the restricted stock were earned
      by
      the consultant on May 16, 2007, July 16, 2007 and September 17,
      2007, respectively. As of September 30, 2008, the restrictions on the 440,000
      shares issued under this contract have lapsed and such shares were
      earned.





On
      August 1, 2007, the Company entered into a Separation Agreement with
      Mr. Roger. Pursuant to the Separation Agreement, all of Mr. Roger’s
      options vested as of the date of the Separation Agreement and in accordance
      with
      the Incentive Plan, Mr. Roger had thirty days to exercise these options,
      which expired unexercised. Finally, 166,667 of the remaining shares of
      Mr. Roger’s restricted stock vested on the date of the Separation Agreement
      and 166,666 of the remaining shares vested on July 31, 2008. Mr. Roger
      agreed not to sell or transfer these shares until after that date.





In
      the
      three months ended June 30, 2008, the Company issued 1,071,500 shares of
      restricted stock to two vendors in lieu of cash payments for investor relations
      services. The result of these settlements was to reduce accounts payable by
      $90,000 and to increase professional fees by $130,000. There were no similar
      arrangements in the first or third quarters of 2008.




The
      following schedule presents shares of common stock issued and outstanding and
      reserved for future issuance as of September 30, 2008:




Common
                Shares Outstanding
            
            
            
            
            
            84,981,812Reserved
                For Future IssuanceOptions
                granted to officers, directors, employees and consultants
            
            
            4,625,000Unearned
                common stock issued for commitment shares
            
            
            175,029Warrants
            
            
            12,683,997
            
            
            17,484,026Total
                shares issued and outstanding and reserved for future issuance at
                September 30, 2008.
            
            
            
            
            
            102,465,838




F-30




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




**10. Related
      Party Transactions**




A
      company
      controlled by a former Chairman of the Board provided office space, accounting
      and other services to the Company at a cost of approximately $2,500 per month,
      through June 2007, to the Company’s Irish subsidiary. For the three and
      nine months ended September 30, 2008 and 2007 and for the period
      October 14, 2000, (inception) through September 30, 2008, the Company paid
      $0, $0, $2,873, $27,744 (of which approximately $16,700 related to the first
      nine months of 2007), and $207,595, respectively, to the company controlled
      by
      the former Chairman. At September 30, 2008, there was no amount accrued as
      a
      payable to this related party.




Included
      in Other receivables at September 30, 2008 and December 31, 2007 is $24,729
      and $15,611, respectively, which primarily represents travel advances made
      to
      employees. Included in Accounts payable at September 30, 2008 and
      December 31, 2007 is $279,601 and $150,486, respectively, which primarily
      represents directors’ fees and travel expenses reimbursable to
      employees.




The
      Company has entered into two separate consulting contracts with a former
      shareholder and a current shareholder 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. The company
      incurred expenses of $32,540, $116,185, $37,059, $107,735 and $737,137 for
      the
      three and nine months ended September 30, 2008 and 2007 and for the period
      October 14, 2000 (inception) through September 30, 2008,
      respectively.




**11.
      Commitments**




**Operating
      leases**




The
      Company leases office space and certain office equipment under agreements that
      are accounted for as operating leases. As of September 30, 2008, future minimum
      lease payments under non-cancelable operating leases were as
      follows:




Operating
      Leases




2008
            
            $
            22,1692009
            
            
            15,400Total
            
            $
            37,569




Rent
      expense under the leases with unrelated parties was $54,291 and $140,361 the
      three and nine months ended September 30, 2007 and $45,262, $138,602, and
      $652,734 for the three and nine months ended September 30, 2008 and for the
      period October 14, 2000 (inception) through September 30, 2008,
      respectively.




**12.
      Subsequent Events**




**KL
      Transaction**





On
      October 9, 2008, the Company entered into a term loan agreement (the
“Agreement”) with KL Energy Corporation (“KLE”), to provide up to $1.0 million
      in funding for working capital. In addition, the Company signed a Supply and
      Distribution Agreement (the “Supply Agreement”) with KLE to develop the
      commercial market in the United States and Canada for O2DieselTM.





The
      Agreement provides an initial loan of $250,000 in the form of a secured
      promissory note (the “Note”) at an annual interest rate of 10%, with the
      interest rate increasing to 12% in any period in which there is a default.
      Pursuant to the terms of the Agreement, the Company may make additional draws
      upon the delivery of written requests to KLE specifying the amount and use
      of
      the funds. The Agreement matures on March 31, 2009 (“Maturity Date”). Interest
      accruing on the loan will be paid on the Maturity Date. On the Maturity Date,
      KLE has the option of converting the outstanding loan obligation into shares
      of
      common stock of the Company, at a conversion rate equal to the price of the
      Company’s stock on the Maturity Date. If the Company fails to pay the loan on
      the Maturity Date, the Company will pay KLE an indemnification fee equal to
      20%
      of the maximum principal amount outstanding during the term of the Agreement.
      As
      security for the loan, the Company has provided a senior security interest
      to
      the Company’s intellectual property. The Agreement and Note contain certain
      events of default. There are no financial covenants related to this
      loan.





F-31




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




**12.
      Subsequent Events (continued)**





The
      parties also entered into a Supply Agreement on October 9, 2008, in which KLE
      and the Company will jointly develop the market for O2DieselTMin the United
      States and Canada during a three year period. As part of the Supply Agreement,
      KLE will be the exclusive distributor of O2DieselTM within the territory.
      Subsequent to signing this agreement, the Company and KLE agreed to transfer
      several of the Company’s employees to KLE, effective November 1, 2008 in order
      to introduce KLE to the North American marketplace in a fashion that was both
      expeditious and uninterrupted for O2Diesel customers.




F-32




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**September
      30, 2008**




**ITEM
      2. MANAGEMENT’S DISCUSSION AND ANALYSIS OR RESULTS 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 September 30, 2008.




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.




From
      July 2003 through October 2008, the Company has raised approximately $37
      million for its operations. During the fourth quarter of 2008, the Company
      will
      need to raise additional working capital. If the Company is unable to timely
      secure additional funding, we may need to restructure or significantly curtail
      our operations, divest all or a portion of the business, file for bankruptcy
      or
      cease operations.





On
      April
      28, 2008, the Company announced that it began trading on the Pink Sheet
      Electronic Quotation Service under the trading symbol OTOD.PK. The Company’s
      shares then began to trade under the symbol OTOD.OB on or about May 26,
      2008.




**Transactions
      During the Third Quarter of 2008**




**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, had been in the process of developing
      a new fuel-grade ethanol plant with planned capacity of 100 million gallons
      per
      year to be built in two 50 million gallon trains (each a “Train “).




The
      Agreement required 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 was required to 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 as well as corn feedstock.
      Under the terms of the share exchange agreement, ProEco was 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)**


**September
      30, 2008**




As
      a
      condition to the closing of the ProEco share exchange, the Company was obligated
      to secure the financing necessary to complete the construction costs to build
      the Ethanol Plant. Accordingly, the Company was required to raise $60
      to $70 million in debt and between $30 and $40 million in equity in the first
      quarter of 2008 for each train.




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 annual interest rate on the loan is 7% and the
      maturity date of the loan was December 15, 2007.




Current
      trends in the ethanol industry have seen increases in the price of corn and
      other feedstocks as well as a decline in the average selling price of
      ethanol.  For a number of new plant construction projects, the lack of EPC
      contractor availability has resulted in increased costs and delays in completion
      dates.  On January 8, 2008, the Company announced that due to
      unfavorable market conditions for raising capital for ethanol plants, the
      Company and ProEco had entered into an agreement to extend the Share Exchange
      Agreement and the maturity date of the loan from the Company to ProEco until
      January 31, 2008.  These agreements were subsequently extended again
      until February 29, 2008.  On March 19, 2008, the Company and
      ProEco entered into a letter agreement terminating the Share Exchange Agreement
      and extending the maturity date of the loan from February 29, 2008 until
      November 30, 2008.  The Company and ProEco agreed at that time to
      continue to develop the Ethanol Plant when conditions in the capital markets
      improve.





At
      December 31, 2007, management had evaluated this project based on its assessment
      of the challenges to financing projects of this nature posed by the present
      debt
      and equity markets, as well as the limited likelihood that a buyer would be
      identified for this project in the near future.  Accordingly the Company
      believes that it is prudent not to assign a value to this asset.  As such,
      an impairment charge of $1,288,614 was warranted and this adjustment was
      recorded in December 2007.





Based
      on
      FIN 46R, the Company was the holder of the majority of the risks and
      rewards relating to ProEco as of the period ended June 30, 2008. As such, the
      Company was considered to be the “primary beneficiary” of ProEco which is deemed
      to be a VIE. (In general, a VIE is a corporation, partnership, limited-liability
      corporation, trust or any other legal structure used to conduct activities
      or
      hold assets that either (i) has an insufficient amount of equity to carry
      out its principal activities without additional subordinated financial support;
      (ii) has a group of equity owners that are unable to make significant
      decisions about its activities; or (iii) has a group of equity owners that
      do not have the obligation to absorb losses or the right to receive returns
      generated by its operations.) Based on these guidelines, the Company determined
      that ProEco was a VIE beginning with the third quarter of 2007 and has included
      ProEco’s assets, liabilities and operating results in its consolidated financial
      statements for all subsequent periods through June 30, 2008. Prior to the third
      quarter of 2007, activity with ProEco was not material.





During
      the period ended June 30, 2008, the Company devoted no significant activity
      to
      the ProEco transaction. ProEco retained the documentation developed to implement
      the proposed project and had secured its option rights to the land at the site
      until October 15, 2008 through an agreement with the Belle Fourche Development
      Corporation in South Dakota. Both the Company and ProEco continued to monitor
      market conditions for the development and financing of ethanol plants during
      2008. However, no opportunities for such a project have been pursued. The
      Company agreed with ProEco to release the land option in the event an
      alternative project for the property were to become available. It is the
      Company’s understanding that the land option expired unexecuted. The Company is
      no longer working with ProEco on this or any other project, which effectively
      terminates the VIE relationship. Accordingly, ProEco’s assets, liabilities and
      operating results after June 30, 2008 were treated as a discontinued operation
      and no longer included in the Company’s consolidated financial statements. A
      summary of the results of this discontinued operation is as
      follows:





**October 14, 2000****(inception)****Three Months**
            
            **Nine Months**
            
            **through****9/30/2008**
            
            **9/30/2007**
            
            **9/30/2008**
            
            **9/30/2007**
            
            **September 30, 2008**Loss
                from ProEco operations
            
            $
            -
            
            $
            (327,216
            )
            $
            (17,258
            )
            $
            (327,216
            )
            $
            (
                417,931
            )Loss
                on impairment of construction in progress
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (1,288,614
            )Gain
                on disposal of ProEco operations
            
            
            89,287
            
            
            -
            
            
            89,287
            
            
            -
            
            
            89,287Loss
                from Discontinued Operations
            
            $
            89,287
            
            $
            (327,216
            )
            $
            72,029
            
            $
            (327,216
            )
            $
            (
                1,617,258
            )





The
      significant assets and liabilities of ProEco as of December 31, 2007 were
      cash ($8,310), accounts payable ($351,005) and accrued expenses
      ($31,304).


2





**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**September
      30, 2008**





**Energenics
      Transactions**




On
      October 17, 2007, the Company announced that it had entered into a private
      financing agreement and a joint venture transaction with Energenics Holdings
      Pte
      Ltd (“Energenics”) funding and commercial support for the development of the
      Asian market. At that time, the parties entered into a Common Stock and Warrant
      Purchase Agreement (the “ *Purchase*  *Agreement* ”)
      pursuant to which Energenics agreed to purchase 2,551,020 shares of the
      Company’s common stock in a private placement, for total proceeds of
      approximately $1.25 million. As part of the transaction, the Company agreed
      to
      issue a warrant to purchase 1,275,510 shares of common stock at an exercise
      price of $0.50 per share, which warrant would be issued upon the closing of
      the
      transactions contemplated by the Purchase Agreement and would become exercisable
      from the date that is six months following the date of issuance until October
      17, 2012 (“ *Investment Warrant* ”).





The
      parties also entered into a Shareholders Agreement, in which Energenics and
      the
      Company would jointly develop the market for O2DieselTM in Asia through O2Diesel
      Asia Limited (“O2Diesel Asia”). Energenics agreed to pay the Company $750,000
      for a fifty percent (50%) equity interest in O2Diesel Asia. The balance of
      the
      interest in O2Diesel Asia was to be held by O2Diesel Europe Limited, a
      wholly-owned subsidiary of the Company. Pursuant to the Supply and Distribution
      Agreement, dated September 15, 2006 (“ *Supply Agreement* ”),
      O2Diesel has supplied its additive to Energenics for the manufacture and
      distribution of O2DieselTM in the Asian Pacific and South Asia.





The
      parties also entered into a License agreement(“ *O2Diesel
      Asia License Agreement* ”),
      whereby O2Diesel Europe Limited (formerly AAE Technologies International Plc)
      (“ *O2Diesel Europe* ”)
      would
      license to O2Diesel Asia certain patents and know-how that are required to
      make
      and sell O2DieselTM in the Territory in exchange for certain payments pursuant to
      the Shareholders Agreement. In addition, the Company was to enter into a similar
      License agreement (the “ *License Agreement* ”
and
      together with the O2Diesel Asia License Agreement, the “ *Licenses* ”),
      with
      O2Diesel Asia, pursuant to which the Company would pay to O2Diesel Asia a
      royalty based on sales of the Company’s product in the Territory.





As
      part
      of the transaction, upon the purchase of a certain quantity of O2D05 or the
      equivalent, the Company would also issue a warrant to purchase 1,500,000 shares
      of common stock at an exercise price of $0.50 per share, which warrant would
      be
      exercisable during the period from the date of issuance until October 17,
      2012 (“ *JV
      Warrant”* ).





Also,
      as
      part of the transaction, upon the achievement by Energenics of certain levels
      of
      additional purchases of O2D05 or the equivalent, the Company was to issue
      additional warrants to purchase up to an aggregate of 6,500,000 shares of common
      stock at a price per share equal to the lesser of $0.50 or 106% of the closing
      price per share (rounded to the nearest cent) of the Company’s common stock on
      the American Stock Exchange on the date such warrants are earned (“ *Market Development Warrants* ) ,” The
      Market Development Warrants were to be exercisable from the date of issuance
      to
      October 17, 2012.





On
      December 10, 2007, the Company and Energenics entered into an amendment (the
      “ *Amendment* ”)
      to the
      Common Stock and Warrant Purchase Agreement, dated October 17, 2007. Pursuant
      to
      the Amendment, the Company agreed to increase the number of shares of common
      stock by 782,313 shares to 3,333,333 shares, which reduced the per share price
      from $0.49 to $0.375. The per share price of $0.375 represented 121% of the
      current market price on the American Stock Exchange the day prior to the signing
      of the Amendment. In addition, the Company agreed to issue an additional 391,157
      shares exercisable pursuant to the warrant associated with the Investment
      Warrant. In addition, the Company was to issue additional warrants (the
“ *Additional Warrants* ,” and
      collectively, with the Investment Warrant, the Market Development Warrants
      and
      the JV Warrant, the “ *Warrants* ”)
      to
      purchase shares of common stock, upon the purchase of certain quantities of
      O2D05 or the equivalent. Pursuant to the Amendment, the exercise price per
      share
      for the shares associated with these Additional Warrants was also reduced to
      $0.375.




All
      other
      terms and conditions of the transaction remain as provided in the Purchase
      Agreement.


3




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**September
      30, 2008**





The
      common stock and the Warrants were to be issued to the accredited investor
      in a
      transaction that would be exempt from registration pursuant to Section 4(2)
      of
      the Securities Act of 1933, as amended (the “Securities Act”), and/or Regulation
      D promulgated under the Securities Act.





On
      June
      17, 2008, the Company entered into an Amending and Restating Agreement with
      Energenics to reflect the renegotiated terms of previously announced agreements
      to provide $2,000,000 of funding and commercial support to develop the Asian
      market for O2DieselTM, the Company’s ethanol diesel fuel blend.





A ccording
      to the terms of the Amending and Restating Agreement, the original Common Stock
      and Warrant Purchase Agreement dated October 17, 2007, and the subsequent
      Amendment are to be terminated and the 3,333,333 previously issued shares of
      O2Diesel Corporation common stock are to be returned to the Company and retired
      by the Company. In exchange for these shares Energenics acquired an eighty
      percent (80%) equity interest in O2Diesel Asia. This transaction was accounted
      for based on the fair value of the Company’s stock received as of the date of
      the amended agreements, June 17, 2008. These shares were then retired. The
      balance of the interest in O2Diesel Asia is to be held by O2Diesel Europe
      Limited, a wholly-owned subsidiary of the Company. The existing Warrants (as
      amended), Licenses and Supply Agreement will remain unchanged. At September
      30,
      2008, this subsidiary did not have active operations.





On
      June
      17, 2008, and as part of the amended agreements, the Company issued to
      Energenics an unsecured, Convertible Promissory Note for the principal sum
      of
      $750,000. The term of the note is for thirty-six months from the date the Note
      was issued and accrues interest at the rate of 5% per year. Energenics may,
      at
      its option, convert all or part of the principal and interest outstanding on
      this note at a conversion price of $0.145 per share .





The
      Company received $1,250,000 in two deposits on November 14, 2007 and December
      21, 2007 to be applied toward the equity portion of the transaction and $750,000
      in three deposits on July 10, 2008, August 11, 2008 and September 5, 2008 to
      be
      applied toward the Promissory Note. Upon payment of the required Irish stamp
      tax
      associated with the transfer of the O2Diesel Asia shares, the transaction will
      close. The Company anticipates this closing to take place during the fourth
      quarter of 2008.





**KL
      Process Transaction**




On
      March 11, 2008, the Company’s wholly owned subsidiary, O2Diesel Europe,
      entered into an exclusive Technology License and Services Agreement (the “KL
      Agreement”) with KL Process Design Group, LLC (“KL”) whereby O2Diesel Europe
      obtained an exclusive license to use, exploit and sublicense certain KL
      intellectual property, know-how and processes for the production and sale of
      ethanol from feedstocks other than simple sugars and starches (the
“Product”).  KL granted this license to O2Diesel Europe on an exclusive
      basis in Europe, India, Russia and other rapidly developing global
      markets.  Pursuant to the KL Agreement, KL also agreed to provide certain
      services related to the design and construction of production plants necessary
      to produce the Product.





As
      part
      of the KL Agreement, the Company agreed to issue 1,000,000 shares of the
      Company’s common stock to KL as consideration for the license as well as certain
      royalty and design services fees.  The stock is to be issued upon
      commencement of the first project under the Agreement or 18 months after the
      effective date of the Agreement, whichever is earlier. The common stock will
      be
      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.





On
      September 30, 2008, KL Energy Corporation, formerly known as Revive-It Corp.
      (“KLE”) entered into an Agreement and Plan of Merger with KL which provides for
      the merger of KL with and into KLE, and accordingly, KLE and KL filed the
      Articles of Merger with the State of Nevada effecting the merger. All of the
      outstanding membership interests of KL were converted into newly issued shares
      of common stock of KLE, which were issued to the former members of KL. As a
      result of the merger, KL merged with and into KLE, with KLE as the surviving
      corporation. As a result of the merger, KLE succeeded to, acquired all of,
      the
      assets and liabilities of KL, including all of the contractual rights and
      interests of KL. For accounting purposes, the merger was treated as a reverse
      acquisition with KL as the acquirer and KLE as the acquired party. On September
      8, 2008 KLE began trading on the Pink Sheet Electronic Quotation Service under
      the trading symbol KLEG.OB.




On
      October 9, 2008, the Company entered into a term loan agreement (the
“Agreement”) with KLE to provide up to $1.0 million in funding for working
      capital.


4




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**September
      30, 2008**




The
      Agreement provides an initial loan of $250,000 in the form of a secured
      promissory note (the “Note”) at an annual interest rate of 10%, with the
      interest rate increasing to 12% in any period in which there is a default.
      Pursuant to the terms of the Agreement, the Company may make additional draws
      upon the delivery of written requests to KLE specifying the amount and use
      of
      the funds. The Agreement matures on March 31, 2009 (“Maturity Date”). Interest
      accruing on the loan will be paid on the Maturity Date. On the Maturity Date,
      KLE has the option of converting the outstanding loan obligation into shares
      of
      common stock of the Company, at a conversion rate equal to the price of the
      Company’s stock on the Maturity Date. If the Company fails to pay the loan on
      the Maturity Date, the Company will pay KLE an indemnification fee equal to
      20%
      of the maximum principal amount outstanding during the term of the Agreement.
      As
      security for the loan, the Company has provided a senior security interest
      to
      the Company’s intellectual property. The Agreement and Note contain certain
      events of default. There are no financial covenants related to this
      loan.





The
      parties also entered into a Supply and Distribution Agreement on October 9,
      2008, in which KLE and the Company will jointly develop the commercial market
      for O2DieselTMin the United States and Canada during a three year period. As part
      of the Supply Agreement, KLE will be the exclusive distributor of O2DieselTM
within the territory. The Company and KLE agreed to transfer several of the
      Company’s employees to KLE, effective on November 1, 2008 in order to introduce
      KLE to the North American marketplace in an expeditious fashion and to provide
      uninterrupted service for O2Diesel customers.




YellTec
      Transaction





On
      April
      6, 2008, the Company entered into a Letter of Intent (the “LOI”) to acquire all
      the outstanding shares of YellTec GmbH (“YellTec”), a German company which
      specializes in biofuels distribution. YellTec is focused on small to medium
      size
      truck fleets and operates an exclusively German based network of its own
      strategically located fueling points.





The
      parties have agreed to terminate the LOI and not to pursue the acquisition
      in
      light of changed conditions in the market for vegetable oil products. On July
      24, 2008, the Company informed YellTec of its intention to terminate the LOI
      and
      any further efforts related to the transaction.


5




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**September
      30, 2008**





**Operations**




During
      the third quarter of 2008, we continued our efforts to generate sales to our
      targeted fleet customers in North America, South America and India, as well
      as
      our efforts to develop targeted demonstrations in Europe.




*North
      America*




Our
      focus
      for the U.S. has been 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;
                  and
  Ø
              Military
                  installations in non-combat
                  vehicles.




In
      the
      U.S., O2Diesel’s third quarter sales and marketing efforts for fleet sales
      remained focused in the state of California and in the Midwest.  The
      Company maintained its commercial activities at the Port of Long Beach and
      pursued additional opportunities in this market segment at the ports of Oakland
      and Los Angeles. The Company continued its test demonstration of its new
      fuel blend referred to as “O28”, which contains the Company’s proprietary
      additive, ethanol (8%), biodiesel (20%) and regular diesel fuel. At
      Nellis Air Force Base (Nevada) O28 has been proven to be successful
      under extreme heat conditions. During the second quarter of 2008, the Company
      successfully completed a second demonstration at Minot Air Force Base (North
      Dakota) in which the O28 fuel technology was proven to be successful under
      extreme cold weather conditions. During the third quarter of 2008, the Company
      also completed a third test demonstration for the Air Force at Barksdale Air
      Force Base (Louisiana) in which the O28 was tested under extreme humidity
      conditions.  Results from this demonstration were consistent with the
      success we have had at Nellis and Minot. It is expected that this third test
      will be the final field demonstration required by the Air Force in order to
      implement a formal purchasing specification. During the fourth quarter of 2008,
      the Company began discussions with key Air Staff members of the Department
      of
      the Air Force to identify the next steps required to be able to make O28
      available to the Air Force on a widespread basis. As additional support for
      these efforts, we are focused on conducting storage stability tests for our
      fuel
      as well as reviewing the training and procedures that will be required for
      a
      larger scale implementation of O2DieselTM and O28 on additional DoD
      installations.




We
      also
      maintained our CityHomeTM demonstration program as a means of documenting
      operating performance data.  CityHomeTM is a marketing and sales initiative
      directed at city 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.





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 consolidated statement of operations. With regard to the
      advertising space, 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.


6




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**September
      30, 2008**




In
      the
      third quarter of 2008, we did not initiate any new CityHomeTM programs, but we
      did continue with several small school bus fleets in Chicago and South
      Dakota.  To date, we have used this initiative as a 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 several CityHomeTM programs, the fleet
      demonstrations executed under this program have required 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. The Company’s future involvement with the
      CityHomeTM program has thus been reduced only to programs that can be considered
      cost neutral.




We
      continued our efforts to support and improve the logistics network required
      for
      the delivery of O2DieselTM to fleet and CityHomeTM customers during the third
      quarter. These efforts are focused on developing strategic relationships with
      ethanol producers and distributors in order to improve both quality consistency
      and price stability. During the third quarter, the Company continued to
      renegotiate its supply agreement with an ethanol industry group to supply
      limited amounts of ethanol at preferential pricing for our Midwestern
      customers.




During
      the latter half of 2007, the U.S. ethanol industry experienced several economic
      and logistical challenges to the general expansion of production capacity. 
The prices of various ethanol feedstocks, most notably corn, have increased
      while, at the same time, ethanol prices saw a general decline as new production
      capacity comes on line.  In addition, the demands on experienced EPC
      contractors increased, particularly with the need for qualified skilled labor
      to
      build new plants.  As a consequence, many new projects experienced
      increased construction costs and project delays at a time when the profitability
      of the industry was tested.  At the end of the year, market conditions for
      raising capital for ethanol plants had become so unfavorable that the Company
      announced its decision to delay the project with ProEco to develop an ethanol
      plant until conditions in the capital markets improve. At the end of the third
      quarter, the Company decided to end its relationship with ProEco and terminate
      the project to build a new ethanol plant.




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 September 30, 2008,
      the Company continued its efforts to register O2DieselTM fuel with the EPA and
      waited for a formal response from the agency to the significant test data and
      documentation submitted to support its position that O2DieselTM is “substantially
      similar” to diesel fuel and should qualify for EPA registration. It is the
      Company’s view that this represents the major outstanding hurdle in registering
      O2DieselTM fuel for commercial use. At the end of the third quarter, the EPA
      indicated that they were continuing to review our submission. The Company also
      continued its efforts to complete the protocols to allow O2DieselTM to be
      classified as a California Diesel Emissions Control Strategy (DECS) by the
      California Air Resources Board.




A
      member
      of the Company chairs the task force that is developing an ethanol diesel
      specification for use as an American Society for Testing and Materials (ASTM)
      specification. The latest revision to the specification was based on the results
      of the initial voting on the original ballot submitted in December 2006 as
      well as subsequent ballots, the latest of which was submitted and voted on
      during the June 2008 meeting. While the ballot was not successful at this
      meeting, each ballot has shown a reduced variety of negative votes, which the
      task force has continued to address.  The major topics at issue with this
      ASTM ballot appear to be centered on safety and engine warranty issues. Both
      of
      these issues have been substantially addressed through extensive testing and
      demonstration data and real world field usage of the fuel. The task force will
      continue to address ASTM member concerns and anticipates making progress on
      these fronts.





Finally,
      during the third quarter we continued to develop contract proposals for
      submission to the Department of Energy and the Department of Defense to utilize
      the $2.6 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. The work undertaken for our regulatory approvals has taken more time
      than originally anticipated and, while we continue our efforts in these areas,
      it is not possible to predict when these final approvals will be
      obtained.





*South
      America*





In
      Brazil, the roll out of our product has been much slower than planned, despite
      the fact that we have succeeded in verifying our technology in several earlier
      demonstration fleets. The cost of ethanol in Brazil has shown seasonal market
      fluctuations, which has made it difficult to produce our blended fuel at a
      consistently cost competitive level. Also, obtaining government approvals and
      gaining market awareness has taken longer than we anticipated. In response
      to
      these issues, we have made a decision to follow a less aggressive marketing
      strategy for Brazil and taken steps to reduce our overhead. We are targeting
      customers in this market on a very focused basis, supporting them with a small
      consulting staff that performs our marketing and technical functions. Our
      marketing plans have been scaled back until we have a solid base of customers.
      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.


7




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**September
      30, 2008**




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.





During
      the third quarter of 2008, we successfully completed our pilot project with
      a municipal bus fleet in Curitiba.  O2DieselTM fuel was used for more than
      twelve months without any technical problems encountered. The Company also
      tested the use of its fuel blending equipment and the municipal authorities
      are
      discussing the possibility of small scale commercial use of O2DieselTM starting
      in the first quarter of 2009.





The
      Company also supported a pilot demonstration in Paraguay involving four
      municipal transit vehicles. The test program is expected to be concluded in
      the
      fourth quarter of 2008, with a larger scale validation test program anticipated
      to be conducted in the first quarter of 2009.





We
      have
      seen a reduction in the market price of ethanol during this time period. 
However, just as in the U.S., we have found that commercial success in Brazil
      will depend on reliable, cost competitive supplies of ethanol.  It is the
      Company’s intention to identify strategic partners in the ethanol industry in
      Brazil and throughout South America in order to negotiate such supply
      contracts.





In
      2007,
      the Company announced the appointment of Fair Energy, S.A. as our distributor
      for several new markets in Central and South America.  The Company has
      targeted demonstration programs in Columbia, Paraguay and Bolivia for
      implementation over the next several quarters.  The first of these
      demonstrations was started in the fourth quarter of 2007 in Anunción, Paraguay’s
      capital and was successfully completed during the quarter ended March 31,
      2008.  The Company is currently waiting to see if the government will
      require expanded use of the fuel in that country in the fourth quarter of
      2008.





During
      the third quarter of 2008, the Company reached an agreement with its 25%
      minority shareholder and two former employee shareholders (less than 1%) of
      our
      Brazilian subsidiary, in which these shareholders agreed to relinquish their
      shares to the Company in return for a general release of obligations to the
      Brazilian subsidiary. The transaction was finalized in an agreement dated
      September 17, 2008.





While
      South America remains an important market, the timing of expanded commercial
      activity here continues to be slower than anticipated and the Company cannot
      predict when this will occur.





*Europe*





During
      the third quarter of 2008, the Company continued its efforts to define the
      EU
      regulatory requirements and to identify market opportunities for testing and
      potential commercialization.  Our efforts in this region remain focused on
      developing fuel blending capability, identifying flame arrestor and other
      hardware requirements for fleet fueling, working with local and EU regulators
      to
      clarify the application of existing regulations to ethanol-diesel as an
      alternative fuel, establishing procedures to be used to manage fleet conversions
      to our fuel and discussing test demonstration opportunities.  The Company
      continued its demonstration programs with municipal bus fleets in France
      (Veolia) and Spain (Tussam).  These demonstrations are funded by government
      grants and the Company.  Upon successful completion of these
      demonstrations, it is anticipated that the Company will have fulfilled the
      requirements to be able to market O2DieselTM in these countries on a commercial
      basis.  We have identified several additional fleet demonstration
      opportunities in Spain, Italy, the Netherlands and Belgium.  We expect
      these or other potential customers to develop into new demonstration programs
      in
      2009.





On
      March 11, 2008, the Company announced that its wholly-owned subsidiary,
      O2Diesel Europe, had signed the KL Agreement with KL to develop the next
      generation of ethanol production known as Cellulosed-Based Ethanol (CBE). 
The agreement secures the Company’s rights to expand KL’s cellulosic to ethanol
      production technology in Europe, India, Russia and other rapidly developing
      global markets.  The Company views this agreement as a significant
      strategic opportunity to participate in the development of second generation
      renewable fuels in markets which are facing immediate regulatory requirements
      to
      replace traditional fossil fuels, such as the European Union.





On
      July
      24, 2008, the Company notified YellTec of its intent to terminate the LOI to
      acquire this German biofuels distribution company. However, the Company
      continues to believe that these types of transactions represent the appropriate
      strategy to achieve expanded participation in the broader biofuels industry
      as
      well as vertically integrating and controlling the cost of the ethanol fuel
      component for O2DieselTM.


8




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**September
      30, 2008**


*Asia*





Our
      exclusive distributor in this region, Energenics, continued its efforts to
      expand its participation with its first large municipal bus fleet in Karnataka,
      India.  The pace of the conversion of the remainder of this fleet during
      the third quarter was slower than expected, which reduced orders for our product
      significantly. Energenics has indicated that they experienced delays in renewing
      their annual licenses for the sale of O2DieselTM, but that these regulatory
      issues will be overcome in time to place new orders during the fourth quarter
      of
      2008. Energenics has continued to target additional large bus fleets in the
      state of Maharashtra, India.





*Technical
      and Logistical Issues*





Significant
      technical and logistical issues continued to challenge our ability to generate
      sales in the third quarter of 2008. While we have made substantial progress
      in
      addressing these challenges, they have impeded our efforts to commercialize
      O2DieselTM fuel. In general, these challenges fall into the following categories:
      (1) negotiating reliable, price-competitive supplies of fuel grade ethanol,
      (2) logistics of delivering and dispensing O2DieselTM fuel, (3) sourcing and
      installation of flame arrestors and other devices in vehicles and storage
      facilities, and (4) obtaining regulatory approval and an industry accepted
      specification for our “e-Diesel” (ethanol-diesel) fuel. O2Diesel has
      implemented several strategies to meet these challenges and has undertaken
      a
      variety of activities to overcome them and to position O2DieselTM as a premium
      clean-burning fuel.





*(1)* **Negotiating
      reliable, price-competitive supplies of fuel grade ethanol** :    An
      important challenge to our commercialization strategy in 2008 has been the
      price
      and availability of ethanol. The Company has seen that even with a reliable
      supplier, the price of this commodity 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 the price of competing products. For example, starting
      in the second quarter of 2006, many petroleum refiners began replacing methyl
      tertiary butyl ether (MTBE) in gasoline with ethanol. This replacement has
      caused the demand for ethanol to increase dramatically, with a corresponding
      increase in its price. Similarly, the demand for corn has increased
      significantly, since this commodity is the primary ingredient in the production
      of ethanol. In addition, since most ethanol is transported by rail, freight
      costs continue to play a larger role in its price, particularly when the end
      users are geographically distant from the production facilities. While
      production quantities of ethanol have continued to increase, the rise in its
      production and distribution costs have made the cost of O2Diesel TM increase
      in relation to conventional diesel fuel throughout 2007, and, at times, in
      2008.
      It is the Company’s strategy going forward to control the costs of ethanol by
      renegotiating our contract with an ethanol industry group to supply limited
      amounts of ethanol at preferential pricing for our Midwestern customers and
      continuing our efforts to acquire production capacity through our strategic
      relationship with KL.





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 O2Diesel TM be
      of a consistently high quality and that it meet certain other specifications.
      We
      continue to work closely with the industry to identify ethanol suppliers who
      meet our criteria. In addition, it remains the Company’s intention to obtain
      ownership interest in ethanol producing facilities so that we can assure
      competitively priced, high quality ethanol for use in our commercialization
      efforts.





In
      order
      to ensure fuel quality, we have developed a quality control function that
      constantly tests the ethanol, the diesel blended with our additive and the
      final
      blended fuel used by our customers. We have established our own laboratory
      facility to support and enhance our quality control standards, as well as to
      carry out the tests that are necessary to prepare a fleet for conversion to
      use
      O2Diesel TM .
      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.





*(2)* **Logistics
      of delivery, storing and dispensing O2Diesel** **TM** **fuel:** During
      the third quarter, we maintained distribution agreements with fifteen jobbers,
      who in turn have centrally fueled fleets as their customers. We sell additive
      directly to these jobbers and, when required, assist them in locating ethanol
      supplies in order to blend these components with diesel and then sell our fuel
      to their customers. Alternatively, our sales force plans to sell our additive
      directly to companies, governmental port facilities and others that operate
      large centrally fueled fleets. To date, such customers have included centrally
      fueled truck fleets and cargo handling facilities at a major port, however
      our
      sales force plans to market to bus fleets, construction fleets, municipalities,
      and agricultural users. In these transactions, the Company maintains a similar
      working relationship with the customer’s blending facilities as it does with
      third party jobbers. Whether we sell to the jobber or directly to the fleet
      customer, a key part of the relationship is to provide safety and technical
      training regarding the use of the fuel. In addition, our technical staff also
      works with customers to insure that its storage facilities are clean and are
      compatible for storing and dispensing O2Diesel TM .





*(3)* **Sourcing
      and installation of flame arrestors and other devices:** As
      part of the process by which O2Diesel TM was
      approved for sale in California, the California Air Resources Board (“CARB”)
      established several conditions that we must adhere to on an ongoing basis.
      An
      important condition is that all storage tanks in which O2Diesel is stored and
      all vehicles that use the fuel must be fitted with devices know as flame
      arrestors. These 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. In 2004 and 2005, this issue proved to be a serious obstacle and
      negatively impacted our ability to efficiently commercialize our technology
      in
      the U.S. Even though this technology had been used for many years, flame
      arrestors in the required sizes and designs were not yet available as an “off
      the shelf” item for use with our fuel at that time.
      In
      addition, the Company was required to conduct significant research and
      development efforts to identify (and in some cases design) flame arrestors,
      adaptors, primer pumps and other equipment for vehicles that use
      O2Diesel TM in
      different climates and driving conditions. Since that time, the flame arrestor
      challenge has largely been resolved for the vehicles within O2Diesel’s target
      markets. Our technical staff works closely with each customer with regard to
      purchasing and installing flame arrestors and other devices for customer
      vehicles and storage facilities. We will work with customers to source and
      install these devices either directly or in a supervisory role.


9





**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**September
      30, 2008**





*(4)* **Obtaining
      regulatory approval and an industry accepted specification for our “e-diesel”
(ethanol-diesel) fuel:** As
      previously described in the Government Approvals section, the Company is
      continuing its efforts to certify its additives and O2Diesel TM blends
      under the requirements of the EPA, the CARB and the ASTM. Our progress with
      these certification requirements will support our efforts to develop an
      alternative fuel specification for the DoD. Obtaining each of these approvals
      is
      critical to successful commercialization of the Company’s products. The
      timeframe for obtaining these approvals has taken longer than anticipated,
      but
      the Company remains committed to finishing this process in the U.S. as well
      as
      its other global markets.





The
      Company has taken several steps since 2005 to overcome these problems and to
      support the introduction of O2Diesel TM fuel to
      new customer opportunities. First, we have assembled documentation regarding
      the
      design requirements of flame arrestors and equipment used in our markets to
      serve as a basis for a catalogue of flame arrestors and parts that can be used
      for a wide variety of engine/vehicle types and customer applications. We have
      identified several equipment vendors who we now work with so that needed
      equipment can be delivered to customer locations quickly and at competitive
      prices. To support these efforts further, 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. Second, we have developed
      a
      checklist of procedures to be used by our technicians (in conjunction with
      our
      customer) 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. In addition, we have developed a training program that
      will enable our technicians to teach our customers’ fleet maintenance staff
      about handling and storing O2Diesel TM fuel,
      fleet modification and maintenance issues that can be expected. Third, 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 continue to
      be
      evaluated.





All
      of
      these issues have led to greater lead times than expected to convert fleets
      from
      using regular diesel to O2Diesel TM .
      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. Other
      factors, such as the availability of the customer’s vehicles for conversion, the
      degree of participation provided by the customer’s maintenance employees and the
      flexibility provided to O2Diesel employees in assisting the implementation
      process (due to union, insurance or safety reasons) can all add to the length
      of
      time to accomplish these conversion tasks. The Company anticipates that the
      work
      completed since 2005 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.





These
      challenges have presented significant hurdles to commercializing our technology.
      In many 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 to see a port facility and
      a
      municipal bus fleet successfully utilize the fuel for time periods approximating
      three years. Even with this technical knowledge, we will need to continue to
      refine our efforts in this area as well as attain the appropriate regulatory
      certification in order to bring on greater numbers of customers and to better
      predict the cost and timing of work required to have fleets conform to the
      requirements of using our product.





**Third
      Quarter Summary (three months ended September 30, 2008 compared to three months
      ended September 30, 2007)**





Operating
      results from continuing operations for the three month period ended
      September 30, 2008 showed significant improvement compared to results
      during the three month period ended September 30, 2007. Although sales
      and gross margin were
      approximately $108,000 and $33,000 lower in the current quarter, respectively,
      expenses have been reduced dramatically from the prior year’s level. Selling
      and marketing expenses for the
      three months ended September 30, 2008 decreased $203,000 compared to the period
      ended September 30, 2007 largely due to travel and consultant cost reductions. Product
      testing and government grant expenses (net) in
      the three months ended September 30, 2008 were approximately $300,000 lower
      than
      in the comparable period ended September 30, 2007 due to higher government
      reimbursements and a decrease in research and development costs in the U.S.
      and
      Spain. General
      and administrative expenses for the
      three months ended September 30, 2008 were approximately $1.2 million lower
      than
      for the three months ended September 30, 2007 primarily due to personnel
      reductions of approximately $462,000, lower professional fees of $501,000 and
      $87,000 in reduced travel costs. In addition, general and administrative costs
      reflected a decrease of $48,000 in the recognition
      of share-based compensation expense required by SFAS 123(R) versus the same
      period in 2007. Theincome
      tax provisionof
      approximately $24,000 recorded during the three months ended September 30,
      2008
      was attributable to taxable passive income in Ireland that could not be offset
      by cumulative net operating losses. The Gain
      on the sale of stock in subsidiary in the
      amount of $483,000 represents the fair value of the 3,333,333 shares of Company
      stock received from Energenics in exchange for 80% ownership of O2Diesel Asia. Discontinued
      operationsof
      ProEco for the third quarter of 2008 were approximately $416,000 lower than
      the
      comparable prior period as there was little activity in 2008 other than the
      $89,000 gain from terminating this business.




10




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**September
      30, 2008**





**Year-to-Date
      Summary (nine months ended September 30, 2008 compared to nine months ended
      September 30, 2007)**





Operating
      results from continuing operations for the nine month period ended
      September 30, 2008 showed significant improvement, compared to results
      during the nine month period ended September 30, 2007, largely due to overhead
      cost reductions,. Sales were
      approximately $288,000 lower in the first nine months of 2008, and the gross
      margin was approximately $91,000 lower, largely due to the absence of shipments
      to Energenics. Selling
      and marketing expenses for the
      nine month period ended September 30, 2008 were $482,000 lower than during
      the
      comparable period ended June 30, 2007 as CityHome projects were scaled back
      or
      cancelled and consulting and travel costs were reduced. Product
      testing and government grant expenses (net) in
      the nine months ended September 30, 2008 were approximately $418,000 lower
      than
      in the comparable period ended September 30, 2007 as a result of $302,000 in
      reduced research and development spending in the U.S. (net of government
      contract reimbursements) and $117,000 of decreased spending on product
      demonstrations in Spain. General
      and administrative expenses for the
      nine months ended September 30, 2008 were approximately $2.5 million lower
      than
      for the nine months ended September 30, 2007 primarily due to personnel
      reductions of approximately $859,000, lower professional fees of $917,000
      (including $164,000 related to the settlement of legal and consulting fees)
      and
      $75,000 in reduced travel costs. In addition, general and administrative costs
      reflected a decrease of $222,000 in the recognition of share-based compensation
      expense required by SFAS 123(R) versus the same period in 2007. Theincome
      tax provisionof
      approximately $24,000 recorded during the nine months ended September 30, 2008
      was attributable to taxable passive income in Ireland that could not be offset
      by cumulative net operating losses. The Gain
      on the sale of stock in subsidiary in the
      amount of $483,000 represents the fair value of the 3,333,333 shares of Company
      stock received from Energenics in exchange for 80% ownership of O2Diesel Asia. Discontinued
      operations of
      ProEco for the third quarter of 2008 were approximately $399,000 lower than
      the
      comparable prior period as there was little activity in 2008 other than the
      $89,000 gain from terminating this business.





**Cash
      Requirements and Liquidity**





Recently,
      concerns over inflation, energy costs, geopolitical issues, the availability
      and
      cost of credit, the U.S. mortgage market and a declining real estate market
      in
      the U.S. have contributed to increased volatility and diminished expectations
      for the global economy and expectations of slower global economic growth going
      forward. These factors, combined with volatile oil prices, declining business
      and consumer confidence and increased unemployment, have precipitated an
      economic slowdown and fears of a possible recession. If the economic climate
      in
      the U.S. and abroad does not improve from its current condition or continues
      to
      deteriorate, our customers or potential customers could reduce or delay their
      purchases of our products, which would adversely impact our revenues and our
      ability to manage inventory levels, collect customer receivables and ultimately
      our profitability.





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 will need to be raised.  During the fourth quarter of
      2008, we will need to raise additional working capital. If the Company is unable
      to timely secure additional funding, we may need to restructure or significantly
      curtail our operations, divest all or a portion of the business, file for
      bankruptcy or cease operations.





The
      Company has undertaken a number of efforts to address its short-term liquidity
      challenges.  We have pursued new funding initiatives with the KL and KLE
      transactions.  We have renegotiated with Energenics Holdings to complete
      this transaction.  The work under our government contracts has continued,
      which provides funds for Company projects with the military and our efforts
      to
      obtain regulatory approvals.  We have taken a variety of cost control
      actions which have allowed us to reduce our overhead expenses by approximately
      60% when compared to the third quarter of 2007 and by approximately 50% when
      compared to year-to-date figures. 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.  However, the Company’s ability to
      raise additional working capital and to maintain its intellectual property
      remains dependant on both its ability and that of its strategic partners to
      raise funds in a challenging investment environment. There can be no assurance
      that our efforts to attract new investments will be successful.  In
      addition, there can be no 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 $17,258 in sales, and had sponsorship income of $0 associated
      with the CityHomeTM programs, for the three months ended September 30, 2008. 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.





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
      repaid 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.


11




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**September
      30, 2008**




**Research &
      Development**





The
      Company has 82 patents granted or applications pending for nine different
      proprietary fuel and additive product inventions registered with the
      international WIPO (PCT) Registration System. Seven inventions currently have
      44
      patents granted, and 19 applications pending in 22 different countries in
      Europe, North America, South America and Asia. Two additional inventions
      currently have 19 patent applications pending and about to undergo examination
      in 16 different countries. 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 our additive manufacturer (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.





We
      have
      registered a trademark in the U.S. and the European Union for a mark which
      includes the words and numbers O2Diesel TM as well
      as a figurative logo of the words. We also registered trademarks for “CityHome”
(and design) in one class of goods and services, “CITYHO2ME” in one class of
      goods and services and “TODAY’S CLEAN AIR SOLUTION TOMORROW’S BRIGHTER FUTURE”
in 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 September 30, 2008, we incurred expenses of $400,276
      during the first nine months of  2008 in the U.S. in connection with
      governmental sponsored projects and tests. Most of the costs incurred in these
      government test programs were reimbursed by appropriations from the U.S.
      Departments of Energy and Defense.





At
      the
      end of the third quarter of 2008, we have government test programs in progress
      with total remaining costs to complete of approximately $1.8 million. Under
      these programs a wide array of engine tests and product demonstrations are
      to be
      conducted to further prove the emissions benefits of O2Diesel TM and to
      show that the fuel performs well in specific applications.





Included
      in the foregoing programs is the recent completion of a product demonstration
      at
      three Air Combat Command bases for a new fuel blend referred to as “O28”. This
      fuel, which is currently designed for use in non-tactical military equipment,
      contains the Company’s proprietary additive, ethanol (8%), biodiesel (20%) and
      regular diesel fuel. The Air Force Research Laboratory has published a Product
      Description for this fuel. We are currently providing technical support for
      this
      Purchase Description so that the fuel can be purchased routinely by the Defense
      Logistics Agency. Other programs underway include completing the protocols,
      emissions test verification and multimedia assessment to allow
      O2Diesel TM to be
      classified as a Diesel Emissions Control Strategy fuel by the CARB. 
O2Diesel has conducted demonstrations with a number of school bus and transit
      agencies which are evaluating the performance of O2Diesel TM as well
      as O28 for a variety of weather conditions, engine types, and operations.
      Related testing included using O2Diesel TM in large
      mining equipment. These fuels would satisfy Energy Policy Act and Presidential
      Executive Orders requirements for reducing foreign oil dependence.  Over
      the past two years, we initiated projects to develop the basic emissions test
      data necessary to register these fuels for on road application with the EPA.
       Based on the government funding in place, we believe that at least 80% of
      the costs to conduct these tests may be funded by appropriations from the U.S.
      Departments of Energy and Defense.





We
      are
      also investing time and effort in the design and development of less expensive
      flame arrestor technology than what is in use today. This work is more labor
      intensive rather than capital intensive.  However, it is a key step in
      providing a turnkey solution to using these clean burning fuel options. Most
      of
      the design work has been performed by our own personnel and consultants with
      the
      actual fabrication work contracted out to specialized manufacturers. In the
      fourth quarter of 2008, this work will move to the stage where safety
      verification of a simplified slate of hardware will be planned.


12




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**September
      30, 2008**




In
      the
      third quarter of 2008, we did not conduct additional research and development
      projects in Brazil. However, we concluded a fleet demonstration in Curitiba
      as a
      further effort to obtain approvals for O2DieselTM from the agencies that are
      responsible for the country’s petroleum industry and environmental
      laws.





These
      approvals are administered and granted by two Brazilian agencies—ANP and IBAMA.
      ANP is the National Fuel Regulation Agency and IBAMA is the National Environment
      Protection Agency. Approvals are needed from both agencies before O2Diesel TM may be sold in Brazil. In 2004, we submitted applications to both agencies
      and
      received limited, but favorable approvals from each. ANP has classified O2Diesel TM as
      an alternative diesel fuel. In addition, IBAMA, approved O2Diesel TM for off road (e.g. in mining) and railroad applications. Also, in response
      to requests that we submitted to ANP, it granted approval for O2Diesel TM to
      be sold to specific customers and for specific regions in Brazil. In 2005,
      O2Diesel fuel received approvals from the environmental and health secretaries
      of the cities of Rio de Janeiro, Curitiba and Maringá.





O2Diesel
      fuel has also become the first alternative fuel to be certified by the TECPAR’s
      national certification program Transporte Limpo (Clean Transport). For 2008,
      we
      do not anticipate spending significant funds on various product and vehicle
      tests in Brazil.





Similar
      to our efforts in Brazil, the Company also completed a demonstration for a
      municipal bus fleet in Anunción, Paraguay.





**Employees**





As
      of
      September 30, 2008, O2Diesel had eleven full-time employees, ten of which
      are in the U.S. and one is in Europe. We have two temporary employees to support
      general administration and lab testing. Currently, we rely on consultants to
      assist in commercializing our technology and to help us in key technical areas.
      At present, we employ three consultants in the U.S.; one in marketing and
      business development; one chemist; and one in regulatory affairs. The Company
      has entered into a separate consulting contract with a shareholder of its
      Brazilian subsidiary for the purpose of providing office rent and administrative
      services and in lieu of an employment contract with this individual. In Europe,
      we employ one consultant for general management and business
      development.





As
      previously described in the section describing activities with KL Energy, we
      agreed with KLE to transfer several of our employees to KLE in order to provide
      our North American customers with an uninterrupted transition to this new
      distributor. This transfer was effective November 1, 2008, leaving the Company
      with five full-time employees, four of which are in the U.S. and one is in
      Europe. Under our business plan, we do not see the need to add employees in
      the
      U.S., Brazil or Europe unless we need additional technical positions for new
      European market demonstrations in the fourth quarter of 2008. As a result of
      our
      present strategy to utilize strategic geographic distributors to market our
      products, we anticipate that several of our U.S. consultants will either provide
      services for KLE or will be discontinued over the remainder of 2008.





**ITEM
      3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.**





None.





**ITEM
      4. 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 Rules 13a-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 of September 30, 2008, O2Diesel’s disclosure controls and procedures are
      effective.


13




**O2Diesel
      Corporation**


**(A
      Developmental Stage Company)**


**September
      30, 2008**




CHANGES
      IN INTERNAL CONTROLS OVER FINANCIAL REPORTING. On July 14, 2008, two
      directors who were members of the Audit Committee resigned from their positions
      on the Board. The internal control activities of the Audit Committee were
      carried out in a manner consistent with prior reporting periods up to the date
      of their resignation. To maintain good internal review procedures for financial
      reporting, the Company’s management requested that the Form 10-Q filing for the
      period ended September 30, 2008 be reviewed by the current board members, which
      included the remaining member of the Audit Committee. This was reviewed and
      discussed during a board review meeting held on November 12, 2008. Aside from
      this change, 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.





**ITEM
      1A. RISK FACTORS**





Not
      applicable to smaller reporting companies.





**ITEM
      2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
      PROCEEDS.**





Pursuant
      to terms of the Amending and Restating Agreement, the Company issued to
      Energenics an unsecured, Convertible Promissory Note for the principal sum
      of
      $750,000, dated June 17, 2008. The term of the Note is for thirty-six months
      from the date the Note was issued and accrues interest at the rate of 5% per
      year. Energenics may, at its option, convert all or part of the principal and
      interest outstanding on the Note into common stock at a conversion price of
      $0.145 per share.





**ITEM
      3. DEFAULTS UPON SENIOR SECURITIES.**





None.





**ITEM
      4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.**





None





**ITEM
      5. OTHER INFORMATION.**





None


14




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**September
      30, 2008**


**ITEM
      6. EXHIBITS.**




The
      following exhibits are filed herewith.




**Description**31.1
            
            Certifications
                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
            
            Certifications
                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
            
            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




**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:
                November 14, 2008
            By:
            /s/
                Alan RaeAlan
                RaeChief
                Executive Officer
              (Principal
                Executive Officer)




Date:
                November 14, 2008
            By:
            /s/
                David H. ShipmanDavid
                H. ShipmanChief
                Financial Officer
              (Principal
                Financial and Accounting Officer)




15