##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION  FORM 10-QSB [X]
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIESEXCHANGE ACT OF 1934
 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004 [   ]
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGEACT OF 1934
 For the transition period
from to  to Commission File Number: 000-32217 O2DIESEL CORPORATION  WASHINGTON
    
    91-2023525(State or Other
    
    (IRS EmployerJurisdiction of Incorporation)
    
    Identification No.)
 100 COMMERCE DRIVE
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)
APPLICABLE ONLY TO CORPORATE ISSUERS 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, 2004, the registrant had 29,150,823 shares of Common Stock,
$0.0001 par value per share, issued and outstanding Transitional Small Business Disclosure Format (check one) Yes [   ] No [X]




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##### 



02DIESEL CORPORATION
FOR THE QUARTER ENDED September 30, 2004 INDEX TO FORM 10-QSB PAGEPART I FINANCIAL INFORMATIONItem 1. Financial Statements
    
    
    F-1Item 2. Plan of Operation
    
    
    1Item 3. Controls and Procedures
    
    
    5PART IIItem 1. Legal Proceedings
    
    
    5Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    5Item 3. Defaults Upon Senior Securities
    
    
    6Item 4. Submissions of Matters to a Vote of Security Holders
    
    
    7Item 5. Other Information
    
    
    8Item 6. Exhibits
    
    
    8Signatures
    
    
    9
 NOTE REGARDING FORWARD LOOKING STATEMENTS This quarterly report on Form 10-QSB contains forward-looking statements
concerning O2Diesel Corporation (O2Diesel, the Company or the Registrant)
and its future operations, plans and other matters. Any statements that involve
discussions with respect to predictions, expectations, beliefs, plans,
projections, objectives, assumptions or future events or performance (often,
but not always, using phrases such as expects, or does not expect, is
expected, anticipates or does not anticipate, plans, estimates or
intends, or stating that certain actions, events or results may, could,
might, or will be taken or occur or be achieved) are not statements of
historical fact and may be forward looking statements which include
statements relating to, among other things, the ability of O2Diesel to
successfully compete in the fuel additive and fuel distribution business. O2Diesel cautions readers not to place undue reliance on any such
forward-looking statements, which speak only as of the date made. Such
forward-looking statements are based on the beliefs of O2Diesels management as
well as on assumptions made by and information currently available to O2Diesel
at the time such statements were made. Forward-looking statements are subject
to a variety of risks and uncertainties which could cause actual events or
results to differ from those reflected in the forward-looking statements,
including, without limitation, the failure to obtain adequate financing on a
timely basis and other risks and uncertainties risks detailed in O2Diesels
Annual Report on Form 10-KSB, filed with the SEC on March 29, 2004 and other
filings with the SEC. 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, unanticipated challenges in
commercially deploying our products, failure to gain product approval in the
United States or foreign countries for the commercialization and distribution
of our products and failure to capitalize upon access to new markets. The
statements made in this quarterly report are made as of the date of this
quarterly report and O2Diesel undertakes no obligation to update any of the
forward-looking statements to reflect events or circumstances after the date of
such statements made herein, whether as a result of new information, future
events, changes in expectations or otherwise.




---



##### 



PART I. FINANCIAL INFORMATION
ITEM 1. 02Diesel Corporation
(A Development Stage Company)
Consolidated Balance Sheets (unaudited)September 30, 2004
    
    December 31, 2003ASSETSCURRENT ASSETSCash
    
    $
    2,735,260
    
    
    $
    1,084,876Restricted cash
    
    
    
    
    
    
    750,000Accounts receivable
    
    
    29,054
    
    
    
    12,204Due from related parties
    
    
    54,378
    
    
    
    65,309Other receivables
    
    
    72,143
    
    
    
    276,659Inventory
    
    
    96,856
    
    
    
    57,988Prepaid expenses and deposits
    
    
    139,956
    
    
    
    81,380Total current assets
    
    
    3,127,647
    
    
    
    2,328,416FURNITURE AND EQUIPMENTOffice furniture equipment
    
    
    167,415
    
    
    
    115,948Fuel and test equipment
    
    
    132,607
    
    
    
    52,731300,022
    
    
    
    168,679Less accumulated depreciation
    
    
    (65,942
    )
    
    
    (29,296
    )234,080
    
    
    
    139,383TOTAL ASSETS
    
    $
    3,361,727
    
    
    $
    2,467,799LIABILITIES AND STOCKHOLDERS EQUITYCURRENT LIABILITIESAccounts payable
    
    $
    401,416
    
    
    $
    529,923Accrued expenses
    
    
    1,027,389
    
    
    
    884,078Due to related party
    
    
    29,458
    
    
    
    29,642Deferred grants
    
    
    146,513
    
    
    
    65,872Other current liabilities
    
    
    73,182
    
    
    
    54,339Total current liabilities
    
    
    1,677,958
    
    
    
    1,563,854TOTAL LIABILITIES
    
    
    1,677,958
    
    
    
    1,563,854STOCKHOLDERS EQUITYPreferred stock: par value of $0.0001; 20,000,000 shares authorized; 1,550,000
issued and outstanding
    
    
    155
    
    
    
    Common stock: par value of $0.0001; 100,000,000 shares authorized; 29,106,156
and 28,080,372 issued and outstanding respectively
    
    
    2,911
    
    
    
    2,808Common stock subscribed 754,900 shares at December 31, 2003
    
    
    
    
    
    
    1,132,350Additional paid-in capital
    
    
    18,765,463
    
    
    
    11,745,765Common stock subscriptions receivable
    
    
    
    
    
    
    (180,000
    )Accumulated other comprehensive income
    
    
    96,792
    
    
    
    101,128Deficit accumulated during the development stage
    
    
    (17,181,552
    )
    
    
    (11,898,106
    )Total Stockholders Equity
    
    
    1,683,769
    
    
    
    903,945TOTAL LIABILITIES AND STOCKHOLDERS EQUITY
    
    $
    3,361,727
    
    
    $
    2,467,799
 F-1




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##### 



02Diesel Corporation
(A Development Stage Company)
Consolidated Statements of Operations
(unaudited) October 14, 2000Nine months ended September 30,
    
    Three months ended September 30,
    
    (inception)through2004
    
    2003
    
    2004
    
    2003
    
    September 30, 2004Revenue
    
    $
    126,615
    
    
    $
    
    
    
    $
    22,031
    
    
    $
    
    
    
    $
    138,819Expenses:Cost of goods sold
    
    
    92,306
    
    
    
    
    
    
    
    16,030
    
    
    
    
    
    
    
    103,577Selling and marketing
    
    
    1,446,282
    
    
    
    770,313
    
    
    
    499,821
    
    
    
    585,304
    
    
    
    4,195,824Product testing and government grants,
net
    
    
    211,489
    
    
    
    76,212
    
    
    
    91,278
    
    
    
    87,271
    
    
    
    840,725General and administrative
    
    
    3,742,484
    
    
    
    1,852,077
    
    
    
    1,105,882
    
    
    
    726,990
    
    
    
    12,661,645Total operating expenses
    
    
    5,492,561
    
    
    
    2,698,602
    
    
    
    1,713,011
    
    
    
    1,399,565
    
    
    
    17,801,771Operating loss
    
    
    (5,365,946
    )
    
    
    (2,698,602
    )
    
    
    (1,690,980
    )
    
    
    (1,399,565
    )
    
    
    (17,662,952
    )Other income (expense):Interest expense
    
    
    (8,698
    )
    
    
    (39,627
    )
    
    
    (4,846
    )
    
    
    (5,412
    )
    
    
    (99,221
    )Interest income
    
    
    17,128
    
    
    
    2,782
    
    
    
    7,409
    
    
    
    3,729
    
    
    
    30,310Foreign currency gain (loss), net
    
    
    (8,394
    )
    
    
    26,782
    
    
    
    18,266
    
    
    
    (786
    )
    
    
    56,224Other income, net
    
    
    82,464
    
    
    
    653
    
    
    
    443
    
    
    
    653
    
    
    
    348,445Total other Income (expense)
    
    
    82,500
    
    
    
    (9,410
    )
    
    
    21,272
    
    
    
    (1,816
    )
    
    
    335,758Loss before provision (benefit) for income
taxes
    
    
    (5,283,446
    )
    
    
    (2,708,012
    )
    
    
    (1,669,708
    )
    
    
    (1,401,381
    )
    
    
    (17,327,194
    )Provision (benefit) for income taxes
    
    
    
    
    
    
    (44,769
    )
    
    
    
    
    
    
    4,646
    
    
    
    (145,642
    )Net loss
    
    $
    (5,283,446
    )
    
    $
    (2,663,243
    )
    
    $
    (1,669,708
    )
    
    $
    (1,406,027
    )
    
    $
    (17,181,552
    )Net loss per share (basic and diluted)
    
    $
    (0.18
    )
    
    $
    (0.13
    )
    
    $
    (0.06
    )
    
    $
    (0.07
    )
    
    $
    (0.60
    )Weighted average shares outstanding used in
calculating net loss per share:Weighted average shares of common stock
outstanding
    
    
    28,996,722
    
    
    
    46,719,703
    
    
    
    29,106,156
    
    
    
    47,097,481
    
    
    
    62,141,045Recapitalization resulting from the AAE
Technologies International PLC acquisition
    
    
    
    
    
    
    (26,528,157
    )
    
    
    
    
    
    
    (26,823,379
    )
    
    
    (33,270,838
    )Weighted average shares of common stock
outstanding  giving effect to the
recapitalization
    
    
    28,996,722
    
    
    
    20,191,545
    
    
    
    29,106,156
    
    
    
    20,274,101
    
    
    
    28,870,206
 F-2




---



##### 



02Diesel Corporation
(A Development Stage Company)
Statement of Changes in Stockholders (Deficit) Equity
October 14, 2000 (Inception) through September 30, 2004 DeficitCommon
    
    Accumulated
    
    Accumulated
    
    TotalPreferred Stock
    
    Common Stock
    
    Common
    
    Additional
    
    Stock
    
    Other
    
    During the
    
    StockholdersStock
    
    Paid - In
    
    Subscriptions
    
    Comprehensive
    
    Development
    
    EquityShares
    
    Amount
    
    Shares
    
    Amount
    
    Subscribed
    
    Capital
    
    Receivable
    
    Income
    
    Stage
    
    (Deficit)Balance at October 14, 2000 (Inception)Common stock issued in exchange for interest in
wholly owned subsidiaries
    
    
    
    
    
    
    
    
    
    
    43,008,772
    
    
    $
    430,088
    
    
    
    
    
    
    $
    3,603,415
    
    
    
    
    
    
    
    
    
    
    $
    (4,138,684
    )
    
    $
    (105,181
    )Common stock issued on various dates during 2001
    
    
    
    
    
    
    
    
    
    
    24,181,038
    
    
    
    241,810
    
    
    
    
    
    
    
    1,268,031
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,509,841Comprehensive Loss:Foreign currency translation adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,476
    )
    
    
    
    
    
    
    (4,476
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,406,709
    )
    
    
    (1,406,709
    )Balance at December 31, 2001
    
    
    
    
    
    
    
    
    
    
    67,189,810
    
    
    
    671,898
    
    
    
    
    
    
    
    4,871,446
    
    
    
    
    
    
    
    (4,476
    )
    
    
    (5,545,393
    )
    
    
    (6,525
    )Common stock issued at $0.225 per share on
various dates during 2002
    
    
    
    
    
    
    
    
    
    
    703,282
    
    
    
    7,033
    
    
    
    
    
    
    
    515,657
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    522,690Comprehensive loss:Foreign currency translation adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (74,085
    )
    
    
    
    
    
    
    (74,085
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,712,803
    )
    
    
    (1,712,803
    )Balance at December 31, 2002
    
    
    
    
    
    
    
    
    
    
    67,893,092
    
    
    
    678,931
    
    
    
    
    
    
    
    5,387,103
    
    
    
    
    
    
    
    (78,561
    )
    
    
    (7,258,196
    )
    
    
    (1,270,723
    )Common stock issued on various dates during 2003
    
    
    
    
    
    
    
    
    
    
    555,556
    
    
    
    5,556
    
    
    
    
    
    
    
    119,444
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    125,000Common stock issued for consulting services
    
    
    
    
    
    
    
    
    
    
    200,000
    
    
    
    2,000
    
    
    
    
    
    
    
    43,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    45,000Common stock issued for remaining interest in
subsidiaries on July 15, 2003
    
    
    
    
    
    
    
    
    
    
    4,356,200
    
    
    
    43,562
    
    
    
    
    
    
    
    46,323
    
    
    
    
    
    
    
    
    
    
    
    (409,614
    )
    
    
    (319,729
    )Common stock issued upon exercise of stock
options on various dates during 2003
    
    
    
    
    
    
    
    
    
    
    8,670,881
    
    
    
    86,709
    
    
    
    
    
    
    
    1,131,595
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,218,304Recapitalization resulting from AAE acquisition
on July 15, 2003
    
    
    
    
    
    
    
    
    
    
    (56,928,690
    )
    
    
    (814,283
    )
    
    
    
    
    
    
    814,283
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Common stock issued at $1.50 per share on
various dates during 2003
    
    
    
    
    
    
    
    
    
    
    3,333,333
    
    
    
    333
    
    
    
    
    
    
    
    4,999,667
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,000,000Expenses related to 2003 issuance of common
stock and recapitalization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (795,650
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (795,650
    )Subscriptions for 754,900 shares of common stock
at $1.50 per share on various dates during 2003
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,132,350
    
    
    
    
    
    
    
    (180,000
    )
    
    
    
    
    
    
    
    
    
    
    952,350Comprehensive loss:Foreign currency translation adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    179,689
    
    
    
    
    
    
    
    179,689Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,230,296
    )
    
    
    (4,230,296
    )Balance at December 31, 2003
    
    
    
    
    
    
    
    
    
    
    28,080,372
    
    
    
    2,808
    
    
    
    1,132,350
    
    
    
    11,745,765
    
    
    
    (180,000
    )
    
    
    101,128
    
    
    
    (11,898,106
    )
    
    
    903,945Common stock issued at $1.50 per share on
various dates during 2004
    
    
    
    
    
    
    
    
    
    
    1,025,784
    
    
    
    103
    
    
    
    (1,132,350
    )
    
    
    1,535,770
    
    
    
    180,000
    
    
    
    
    
    
    
    
    
    
    
    583,523Preferred stock issued on various dates during
2004
    
    
    1,550,000
    
    
    
    155
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,483,928
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,484,083Comprehensive loss:Foreign currency translation adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,336
    )
    
    
    
    
    
    
    (4,336
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (5,283,446
    )
    
    
    (5,283,446
    )1,550,000
    
    
    $
    155
    
    
    
    29,106,156
    
    
    $
    2,911
    
    
    
    
    
    
    $
    18,765,463
    
    
    
    
    
    
    $
    96,792
    
    
    $
    (17,181,552
    )
    
    $
    1,683,769
 F-3




---



##### 



02Diesel Corporation
(A Development Stage Company)
Consolidated Statements of Cash Flows
(unaudited) Nine months ended September 30,
    
    Three months ended September 30,
    
    October 14, 2000
(inception) through2004
    
    2003
    
    2004
    
    2003
    
    September 30, 2004Cash flows from operating activitiesNet loss
    
    $
    (5,283,446
    )
    
    $
    (2,663,243
    )
    
    $
    (1,669,708
    )
    
    $
    (1,406,027
    )
    
    $
    (17,181,552
    )Adjustments to reconcile net loss to net cash used in operating activities:Depreciation
    
    
    36,646
    
    
    
    19,698
    
    
    
    13,533
    
    
    
    6,006
    
    
    
    121,669Amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    7,786Write off of patent
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    337,329Common stock issued for consulting services
    
    
    
    
    
    
    45,000
    
    
    
    
    
    
    
    
    
    
    
    45,000Write off of telephone system
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,538Changes in operating assets and liabilities:Accounts receivable
    
    
    (16,850
    )
    
    
    
    
    
    
    20,924
    
    
    
    
    
    
    
    (29,054
    )Due to/from related parties
    
    
    10,747
    
    
    
    (47,209
    )
    
    
    42,889
    
    
    
    (19,923
    )
    
    
    (24,920
    )Other receivables
    
    
    204,516
    
    
    
    (149,918
    )
    
    
    (16,836
    )
    
    
    (36,101
    )
    
    
    (72,143
    )Inventory, prepaid expenses and deposits
    
    
    (97,444
    )
    
    
    (574,800
    )
    
    
    5,966
    
    
    
    (211,853
    )
    
    
    (236,812
    )Accounts payable
    
    
    (128,507
    )
    
    
    325,966
    
    
    
    (277,987
    )
    
    
    18,950
    
    
    
    401,416Accrued expenses
    
    
    143,311
    
    
    
    445,651
    
    
    
    61,350
    
    
    
    133,666
    
    
    
    1,027,389Deferred grants
    
    
    80,641
    
    
    
    
    
    
    
    57,580
    
    
    
    
    
    
    
    146,513Other current liabilities
    
    
    18,843
    
    
    
    54,341
    
    
    
    3,055
    
    
    
    
    
    
    
    73,182Cash flows used in operating activities
    
    
    (5,031,543
    )
    
    
    (2,544,514
    )
    
    
    (1,759,234
    )
    
    
    (1,515,282
    )
    
    
    (15,382,659
    )Cash flows from investing activitiesRestricted cash
    
    
    750,000
    
    
    
    (1,500,000
    )
    
    
    
    
    
    
    (1,500,000
    )
    
    
    Purchase of furniture and equipment
    
    
    (131,343
    )
    
    
    (79,941
    )
    
    
    (9,926
    )
    
    
    (17,451
    )
    
    
    (357,287
    )Purchase of Patent
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (345,115
    )Cash flows provided by (used in) financing activities
    
    
    618,657
    
    
    
    (1,579,941
    )
    
    
    (9,926
    )
    
    
    (1,517,451
    )
    
    
    (702,402
    )Cash flows from financing activitiesBridge Loan from DVI
    
    
    
    
    
    
    1,677,506
    
    
    
    
    
    
    
    677,506
    
    
    
    Net proceeds from issuance of preferred stock
    
    
    5,484,083
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,484,083Net proceed from follow-on private placement of common stock
    
    
    583,523
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,535,873Net proceeds from issuance of common stock
    
    
    
    
    
    
    5,383,655
    
    
    
    
    
    
    
    5,258,655
    
    
    
    11,703,573Increase/retirement of bank debt.
    
    
    
    
    
    
    (806,468
    )
    
    
    
    
    
    
    (806,468
    )
    
    
    Cash flows provided by financing activities
    
    
    6,067,606
    
    
    
    6,254,693
    
    
    
    
    
    
    
    5,129,693
    
    
    
    18,723,529Effect of exchange rate changes on cash
    
    
    (4,336
    )
    
    
    224,240
    
    
    
    (17,110
    )
    
    
    265,268
    
    
    
    96,792Net increase (decrease) in cash
    
    
    1,650,384
    
    
    
    2,354,478
    
    
    
    (1,786,270
    )
    
    
    2,362,228
    
    
    
    2,735,260Cash at beginning of period
    
    
    1,084,876
    
    
    
    119,139
    
    
    
    4,521,530
    
    
    
    111,389
    
    
    
    Cash at end of period
    
    $
    2,735,260
    
    
    $
    2,473,617
    
    
    $
    2,735,260
    
    
    $
    2,473,617
    
    
    $
    2,735,260Supplemental Disclosure:Cash paid for Interest
    
    $
    8,698
    
    
    $
    39,627
    
    
    $
    4,846
    
    
    $
    5,412
    
    
    $
    99,221
 F-4




---



##### 



O2Diesel Corporation
(A Development Stage Company) 1. Nature of Operations O2Diesel Corporation (O2Diesel or the Company) is in the development stage
and has developed a proprietary additive product designed to improve the
performance of distillate liquid transportation fuels by facilitating the
addition of ethanol as an oxygenate to these fuels. The additive stabilizes and
enhances the blending of fuel grade ethanol with diesel fuel. Blending the
Companys additive with ethanol and various grades of diesel fuel, in turn,
creates a proprietary clean burning fuel called O2Diesel. The Companys
products are designed for use by diesel powered vehicles including centrally
fueled truck and bus fleets, railroads, municipal fleets, and various types of
diesel equipment used for on and off-road construction, mining and agriculture,
as well as in stationary generators and port facilities. The Company has co-developed its additive technology with Cognis Deutschland
GmbH (Cognis), a German based manufacturer of specialty chemicals. Under its
arrangement with Cognis, the Company has world-wide marketing and sales rights
and Cognis has world-wide manufacturing rights. Cognis performs research and
development work in conjunction with O2Diesel, and produces O2Diesels additive
products for all of the regions targeted by the Company for commercialization
of
its additive products. To date, the Companys operations have been primarily focused on raising
capital, performing product tests and demonstrations, and bringing its products
to market in the U.S., Canada and Brazil. In April 2004, the Company signed
a Supply and Distribution Agreement with a Saudi Arabian company for the sale
of its additive product in Saudi Arabia and two other Middle-Eastern countries.
Since the execution of the contract, the Company has encountered business and
economic setbacks related to the contract that cause management to challenge
the value of the contract. The Company now believes it is unlikely that this
contract in its present form will have any value for the foreseeable future. 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. 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. On June 15, 2004, the American Stock Exchange approved an application to list
46,518,898 shares of the Companys common stock under the symbol OTD. Trading
of the Companys shares on the exchange began July 1, 2004. 2. Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements include the accounts of the Company and
all affiliated subsidiaries. All significant intercompany balances and
transactions have been eliminated in consolidation. Restricted Cash Restricted cash consists of cash held in the Companys bank account. These
funds were to be released based on the timing set forth in documents to the
July 15, 2003 transaction, which provided for the release of the restricted
funds in equal amounts on two dates  October 15, 2003 and January 15, 2004.
Such funds were released on those dates. F-5




---



##### 



O2Diesel Corporation
(A Development Stage Company) 2. Summary of Significant Accounting Policies (continued) Concentration of Credit Risk and Allowance for Doubtful Accounts Due to the limited volume of sales, concentrations of credit risk with respect
to accounts receivable are limited. An allowance for doubtful accounts
receivable of $26,097 was considered necessary at September 30, 2004. No
allowance for doubtful accounts receivable was deemed necessary at December 31,
2003. Inventories Inventories, consisting of fuel additive and cetane held at third party
locations, are stated at the lower of cost as determined using the first in,
first out (FIFO) method or market value. Furniture and Equipment 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 furniture and equipment
are as follows: Office furniture and equipment:
    
    3 to 5 yearsFuel and test equipment:
    
    5 years
 Long-Lived Assets Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for the
Impairment or Disposal of Long Lived Assets was issued in August 2001 and
adopted by the Company on January 1, 2002. In accordance with SFAS No. 144, the
carrying values of intangible assets and other long-lived assets are reviewed
on a regular basis for the existence of facts or circumstances that may suggest
impairment. The Company recognizes an impairment when the sum of the expected
undiscounted future cash flows is less than the carrying amount of the asset.
Impairment losses, if any, are measured as the excess of the carrying amount of
the asset over its estimated fair value. Financial Instruments The carrying value of cash, accounts receivable, due to/from related parties,
and accounts payable approximate fair value due to the relatively short
maturity of these instruments. Revenue Recognition Revenue from the sales of product by the Company is recognized and recorded
upon the passage of title to the customer. Sales of the Companys product may
also be made by its exclusive sales agent for the United States and Canada. On
these sales, the Company will be paid a share of the gross profit realized from
each sale to the end user. The Company will record
revenue earned in these cases upon notification of a completed sale to the end
user. Shipping and Handling Costs The Company classifies costs associated with shipping and handling activities
within cost of goods sold in the consolidated statements of operations.
Shipping and handling costs were $2,229 and $10,174 for the three and nine
months ended September 30, 2004, respectively, and were $12,115 for the period
October 14, 2000 (inception) through September 30, 2004. No shipping and
handling costs were incurred for the three and nine months ended September 30,
2003. Advertising Expenses Advertising expenses are expensed as incurred. Advertising expense was nil for
the three and nine months ended September 30, 2004 and was nil and $62,500 for
the three and nine months ended September 30, 2003, respectively. Advertising
expenses were $500,000 for the period October 14, 2000 (inception) to September
30, 2004. F-6




---



##### 



O2Diesel Corporation
(A Development Stage Company) 2. Summary of Significant Accounting Policies (continued) Research and Development Costs Research and development costs are expensed as incurred. Product Test and Demonstration Appropriations The Company receives appropriations from U.S. governmental agencies to fund
certain of its product testing and demonstration programs. The Company
evaluates the conditions of the appropriation and either increases revenue,
decreases expenses or reduces the cost of furniture and equipment depending
upon the attributes of the underlying grant. Appropriations are not recognized
until there is reasonable assurance that the Company will comply with the
conditions
of the grant and that the monies under the grant will be received. Net Loss Per Common Share (basic and diluted) Basic net loss per common share is computed by dividing the net loss available
to common shareholders by the weighted average number of common shares
outstanding during the period. Diluted net loss per share gives effect to all
dilutive potential common shares outstanding during the period using the
if-converted method. Diluted net loss per share excludes all potential dilutive
common shares if their effect is anti-dilutive. The weighted average number of
shares used to compute basic and diluted loss per share is the same since the
effect of the dilutive securities is anti-dilutive. Stock Based Compensation The Company accounts for stock option grants in accordance with APB Opinion 25,
Accounting for Stock Issued to Employees (APB 25) and related
interpretations. Under APB 25, because the exercise price of the stock options
equaled the fair value of the underlying common stock on the date of grant, no
compensation cost is recognized. In accordance with SFAS 123, Accounting for
Stock-Based Compensation, the Company does not recognize compensation expense
based on the fair value of the options granted at grant date. If the Company
had elected to recognize compensation expense based on the fair value of the
options granted at grant date, net loss and net loss per share would not have
been materially different. Income taxes Income taxes are accounted for using the liability method whereby deferred tax
assets or liabilities are computed based upon the difference between the
financial statement and income tax basis 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 expenses 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 the deferred tax assets will not be realized, a valuation allowance
is required to reduce the deferred tax assets to the amount that is more likely
than not to be realized. Future changes in such valuation allowance would be
included in the provision for deferred income taxes in the period of change. Use of Estimates The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting periods. Actual results could differ from those estimates. Foreign Currency Translation 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 current exchange rates, and the income
and expenses have been translated using historical exchange rates. The
adjustments resulting from translation have been
recorded separately in stockholders (deficit) equity as other comprehensive
income (loss) and are not included in determining consolidated net income
(loss). As of September 30, 2004, other comprehensive income included $96,792
of cumulative income from foreign currency translation. F-7




---



##### 



O2Diesel Corporation
(A Development Stage Company) 2. Summary of Significant Accounting Policies (Continued) 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. Reclassification Certain amounts in the 2003 consolidated financial statements have been
reclassified to conform with the 2004 presentation. 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, 2004 and the results of operations and cash flows presented
herein from inception (October 14, 2000) through September 30, 2004 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, 2004. 3. Government Appropriations Appropriation from the Department of Energy In 2002, the Company received an appropriation of $1,107,734, which was
increased to $2,039,650 as of September 15, 2004, from the U.S. Department of
Energy (DOE) to test the Companys fuel additive as well as its blended fuel,
O2Diesel. This appropriation is managed for the DOE by the National Renewable
Energy Laboratory (NREL) under a contract which, as amended, continues until
December 31, 2005. 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. As of September 30, 2004, the Company had incurred
$865,087 towards completion of the contract, leaving a balance of $1,174,563 in
costs to complete the contract. From the inception of the contract in December
2002 through September 30, 2004, the Company has billed NREL $692,070, of which
$64,942 is included in other receivables as of September 30, 2004. Appropriation from the Department of Defense In 2003, the Company received an appropriation of $1,000,000 from the
Department of Defense to test O2Diesel 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 O2Diesel 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 done are treated
as a reduction to expense over the period earned. The period of performance for
this program runs from October 7, 2003 to December 31, 2004. As of September
30, 2004, the Company had incurred $130,352 leaving a balance of $669,648 in
costs to complete the program. Through September 30, 2004, the Company had
achieved two milestones and, since inception, has billed $200,000 related to
this appropriation. All amounts billed had been received as of September 30,
2004. F-8




---



##### 



O2Diesel Corporation
(A Development Stage Company) 4. Other Receivables Other receivables consisted of the following: September 30, 2004
    
    December 31, 2003NREL Appropriation
    
    $
    64,942
    
    
    $
    184,850Reimbursement due from Cognis
    
    
    7,201
    
    
    
    11,809CTC Appropriation
    
    
    
    
    
    
    80,000$
    72,143
    
    
    $
    276,659
 5. Accrued Expenses Accrued expenses consisted of the following: September 30, 2004
    
    December 31, 2003Legal and professional fees
    
    $
    481,519
    
    
    $
    728,984Financing fees
    
    
    175,723
    
    
    
    Marketing
    
    
    50,000
    
    
    
    50,000Other
    
    
    320,147
    
    
    
    105,094$
    1,027,389
    
    
    $
    884,078
 6. Income Taxes No provision for Federal and state income taxes has been recorded during the
periods presented due to the Companys significant operating losses in each
period. 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 purposes. Significant components
of the Companys deferred tax assets as of September 30, 2004 are as follows: Net operating loss carryforwards
    
    $
    3,609,000Accrued expenses and deferred revenue
    
    
    208,000Total deferred tax assets
    
    $
    3,817,000Valuation allowance
    
    
    (3,817,000
    )Net deferred tax assets
    
    
    
 Management has determined that a valuation allowance equal to 100% of the
existing deferred tax assets is appropriate given the uncertainty regarding the
ultimate realization of these assets. At September 30, 2004, the Company had
Federal and state net operating loss carryforwards of approximately $8.9
million for income tax purposes. If not used, these carryforwards begin to
expire in 2021 for Federal and state tax purposes. Federal tax rules impose
limitations on the use of net operating losses following certain changes in
ownership. If such a change occurs, the limitation would reduce the amount
of these benefits that would be available to offset future taxable income each
year, starting with the year of ownership change. As of September 30, 2004, the
Company had an Irish net operating loss carryforward of approximately $244,000,
that may be carried forward indefinitely, and a Brazilian net operating loss
carryforward of approximately $430,000 that may be carried forward
indefinitely, but which is subject to annual usage limitations. F-9




---



##### 



O2Diesel Corporation
(A Development Stage Company) 7. 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
has been carried forward after the transaction and the loss per share for all
periods prior to the transaction has been restated to reflect the number of
equivalent common shares received by AAE in the transaction. Issuances of Common Stock In connection with the merger between O2Diesel and AAE in July 2003, the
Company completed a private placement of 3,333,333 shares of common stock at
$1.50 per share. The private placement was partially effectuated through the
issuance of a $4 million convertible note that was convertible into the
Companys common stock at $1.50 per share. In October 2003, the Company repaid
$1,677,500 of the note and the $2,322,500 balance was converted into 1,548,333
shares of common stock. The remaining 1,785,000 shares of common stock issuable
under the private placement were issued to other parties in exchange for cash
proceeds of $2,677,500. The expenses associated with the merger and subsequent
issuances of shares were $795,650 and have been reflected as a reduction of
paid-in capital. During the later half of 2003, the Company received subscriptions for the
issuance of 754,900 additional shares of common stock in conjunction with a
follow-on private placement. The Company received $952,350 in gross proceeds
related to the subscriptions for 634,900 shares and has recorded a subscription
receivable of $180,000 related to the subscriptions for the remaining 120,000
shares. In the first quarter of 2004, the Company received subscriptions for
the issuance of 390,884 shares of common stock pursuant to the follow-on
private placement. The Company received $386,325 in gross proceeds related to
the subscriptions for 390,884 shares, and it collected gross proceeds of
$150,000 for subscriptions that it received in calendar year 2003. A
subscription receivable of $230,001 was recorded as of March 31, 2004 to
reflect balances of $30,000 for subscriptions received in calendar year 2003
and $200,001 for subscriptions received in the first quarter of 2004. In the
second quarter of 2004, the Company received gross proceeds of $50,001 related
to subscriptions received in the first quarter of 2004, and cancelled and
reversed the remaining balance of $180,000 in the subscription receivable
account because the subscriber elected not to purchase the shares. 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 including a finders
fee, 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 in May 2004 approximately $2.1 million, net of all expenses
including a finders fee, 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 issued and placed in an escrow account.
In May 2004, the 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 including a finders fee. F-10




---



##### 



O2Diesel Corporation
(A Development Stage Company) 7. Stockholders Equity (continued) Warrants A wholly-owned subsidiary of the Company entered into a supply and distribution
agreement (the Supply and 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 subsidiary for $1.00 provided certain sales
targets are achieved. The warrant expires on July 10, 2006. To date, none of
the sales targets have been achieved under the Supply and Distribution
Agreement. 8. Related Party Transactions A company controlled by the Chairman of the Board provides office space,
accounting and other services to the Company at a cost of approximately $2,300
per month. For the nine and three months ended September 30, 2004 and 2003, and
for the period from October 14, 2000 (inception) through September 30, 2004,
the Company incurred $22,125, $7,695, $20,318, $6,731 and $124,091,
respectively in expenses related to the company controlled by the Chairman. In August 2004, certain of the corporate officers and all directors agreed to
defer a portion of their salaries, directors fees and consulting fees for a
three month period ending November 30, 2004. At September 30, the officers
were owed $14,458 in deferred salaries, and the directors were owed $10,000 in
deferred directors fees and $5,000 for deferred consulting fees. Included in receivables due from related parties at September 30, 2004 is
$33,778 due from Directors for the individual tax liability in Ireland
attributable to certain consultancy fees paid during 2003 and $20,600 related
to travel advances made to certain employees. 9. Commitments Operating leases The Company leases certain office equipment under agreements that are accounted
for as operating leases. As of September 30, 2004, future minimum lease
payments under non-cancelable operating leases expiring in calendar years
through 2008, were as follows: 2004
    
    $
    20,0662005
    
    
    79,2852006
    
    
    81,5302007
    
    
    83,7752008
    
    
    78,680Total
    
    $
    343,336
 Rent expense under the leases was $55,483 and $18,521 for the nine and three
months ended September 30, 2004, respectively, and was $59,745 for the period
October 14, 2000 (inception) through September 30, 2004. The leases did not
exist prior to December 2003. Options The Company has commitments to grant to certain of its Officers and Directors
options to purchase 3.7 million shares of the Companys Common Stock at $1.50
per share. In general, the options will vest over three years and will expire
10 years from
the date of grant. The stock incentive plan, which was previously approved by
the Board of Directors, was approved by the shareholders at the Companys
annual general meeting on August 17, 2004. The Company will record a
compensation charge for the difference between the fair value of the common
stock and the exercise price of the option on the date of issuance if the fair
value of the common stock exceeds the exercise price of the option on that
date. No stock options had been granted as of September 30, 2004. F-11




---



##### 



O2Diesel Corporation
(A Development Stage Company) 10. Saudi Arabian Supply and Distribution Agreement On April 20, 2004, the Company signed a Supply and Distribution Agreement
(Saudi Agreement) with a Saudi Arabian company (Distributor) under which
the Distributor has been granted the exclusive rights for the sale and
distribution of the Companys additive and O2Diesel for three countries in the
Middle East. As part of the Saudi Agreement, the Distributor has committed to
order and take a minimum amount of additive during each year of the Saudi
Agreement, which by its terms, is to continue for an initial period of five
years with a right of renewal by the Distributor for two successive three year
terms. In the event the Distributor fails to order and take delivery of the
minimum amount required under the Saudi Agreement, the Company may invoice the
Distributor for 75% of the quantity by which the actual amounts fall short of
the required minimum. If the Distributor orders and takes more than the
required minimum in a year, such excess may be carried over to subsequent years
and counted towards the required minimums in future periods. Since the
execution of the contract, the Company has encountered business and economic
setbacks related to the contract that cause management to challenge the value
of the contract. The Company now believes it is unlikely that this contract in its present form
will have any value for the foreseeable future. The Company does not expect to
take any action to compel performance under this contract by the Distributor. F-12




---



##### 



O2Diesel Corporation
(A Development Stage Company)
September 30, 2004 ITEM 2. PLAN OF OPERATION OVERVIEW Business Plan: Overview: The Company is classified as a development stage company as shown on our
unaudited consolidated financial statements for the period from inception
(October 14, 2000) through September 30, 2004. In the second half of 2004, the
Company does not expect to have sales of its additive and O2Diesel in
sufficient volumes to cause the Companys status as a development stage company
to terminate. During the last three months of 2004, we intend to continue our focus on
generating sales to our targeted customers in the U.S., Canada and Brazil. In
line with our sales initiatives, we have expanded our marketing efforts to
target large municipalities and certain truck fleets to encourage these
entities to use clean fuel as part their environmental strategies.
Earlier this year, we were led to believe that significant opportunities may
exist for the sale and distribution of our products in Saudi Arabia and other
countries in the Middle East. As set forth in Note 10 to the Financial
Statements and Item 5 of this report, we signed a Supply and Distribution
Agreement with a Saudi Arabian company in April 2004, for the sale of our
product in Saudi Arabia and two other Middle-Eastern countries. Since the
execution of the contract, the Company has encountered business and economic
setbacks related to the contract that cause management to challenge the value
of the contract. The Company now believes it is unlikely that this contract in its present form
will have any value for the foreseeable future. We are continuing our efforts to establish and improve the logistics networks
required for the delivery of our products. In addition, we will continue a
series of product tests and demonstrations that relate directly to our sales
initiatives and which are designed to meet the needs of our targeted customers.
These tests are intended to confirm the integrity of our product for use in
multiple vehicle types, various kinds of diesel equipment, and in different
environments. 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 September 10, 2003, in contemplation of the
reverse acquisition of 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. 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 O2
Diesel 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. On June 15, 2004, the American Stock Exchange approved an application to list
46,518,898 shares of our common stock under the symbol OTD. Our shares began
to trade on the exchange on July 1, 2004. 1




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##### 



O2Diesel Corporation
(A Development Stage Company)
September 30, 2004 United States and Canada: Our focus for the U.S. and Canada is to target key geographical areas and
specific diesel markets based upon:  
    
    Current and projected quantity of diesel fuel consumption;
    
    High-population centers under strict air quality regulations;
    
    Large concentrations of urban-based, centrally fueled fleets of trucks and buses;
    
    Off-road construction equipment;
    
    Diesel equipment used by port facilities and large-scale mining operations; and
    
    Marketing opportunities centered on public policy and a positive environmental image. In the U.S., O2Diesels initial sales and marketing efforts have focused on the
states of California, Nevada, Texas and, to a lesser extent, the northeastern
states of New York, New Jersey, Pennsylvania, Delaware and Connecticut. Taken
together, these three areas account for about one-third of all diesel fuel used
in the U.S. In Canada, we intend to concentrate our efforts on the countrys
large population centers in the Eastern and Western provinces. In each of these
regions, we will seek to identify potential customers that fit the profile for
the use of O2Diesels products. In selling into the U.S. and Canadian markets, the Company faces several
challenges, centered around the logistics of delivering and dispensing
O2Diesel to potential customers and on the need to install flame arrestors and
other devices in vehicles and storage facilities. O2Diesel has devised
parallel strategies to meet these challenges, as well as to position O2Diesel
as a premium clean fuel. Under the first element of our strategy, we are working to create a network of
diesel fuel jobbers, who have centrally fueled fleets as their customers. To
date, we have signed supply and distribution agreements with ten jobbers
located in the states of California, Nevada and Texas. We plan to sell additive
to the jobbers and assist them in purchasing ethanol by locating ethanol
suppliers or, in limited cases, purchasing and reselling ethanol to them. The
jobbers will blend the additive and ethanol with diesel fuel and then sell
O2Diesel to their customers. Our sales force and technical staff will work
jointly with a jobber and the jobbers customers to assist in the transition
from the use of regular diesel fuel to O2Diesel. A key part of working with
each jobber and its customers will be to provide safety and training materials
covering the use of the fuel. In addition, O2Diesels technical staff plans to
work closely with each customer to facilitate the process of purchasing and
installing flame arrestors in all vehicles, installing auxiliary fuel pumps in some
vehicles, as well as reviewing the customers fueling facilities for
compatibility with O2Diesel. In some cases, we will be responsible for
sourcing and installing the flame arrestors and fuel pumps, arranging
tank cleaning and filtering systems as necessary, and in cases where a customer
may choose to perform these tasks, we will have an oversight role to insure
that all parts and installation work comply with O2Diesels specifications. As part of the second leg of our strategy, our sales force plans to market and
sell O2Diesel directly to companies,
governmental municipalities and others that operate large centrally fueled
fleets. These customers may include large truck and bus fleets, construction
and mining companies as well as port facilities, railroads, and agricultural
users. In these cases,
we will likely be responsible for all logistics required to deliver O2Diesel
to the customer. To achieve this goal, we intend to work with fuel distributors
that have the ability to blend diesel fuel, ethanol and additive for delivery
to a customers central fueling location. O2Diesel will arrange for the
purchase of ethanol and will supply additive and, in some cases, may even
arrange for the purchase of diesel fuel by the customer. In the process of
transitioning a customers fleet to O2Diesel, we need to put in place the
logistical support to insure that fuel is delivered on a timely basis. To
accomplish this, O2Diesel is seeking to create a network of transportation
providers, ethanol suppliers and in limited cases, wholesalers of diesel fuel.
With large fleet customers, our technical staff will work closely with the
customer to prepare the vehicles or other equipment to use O2Diesel. This will
include a review of the customers fueling facilities for cleanliness and
compatibility to O2Diesel, arranging tank cleaning and filtering systems as
necessary, as well as purchasing and installing flame arrestors and fuel
pumps or assisting the customer to do so. As a part of our marketing strategy of targeting large municipal and certain
company fleets, we have developed and are testing a marketing concept which at
the outset has been directed primarily to municipal transit authorities. Under
this concept, the municipality will incorporate into its environmental policy
the benefits that using O2Diesel brings to the community. Preliminary
marketing efforts have shown that an initiative encouraging municipalities to
use of O2Diesel as 2




---



##### 



O2Diesel Corporation
(A Development Stage Company)
September 30, 2004 part of their commitment to improve air quality may be a significant driver for
the sale of O2Diesel. As part of this concept, we will assist municipalities
to defray the cost of using O2Diesel by arranging for corporate sponsors to
participate with the
municipalities in the cost and the benefits of being associated with using a
clean burning fuel. Following a successful launch with municipal fleets, we
hope to begin testing this program with a few large commercial fleets. In these
fleets, we will develop joint branding initiatives that leverage the benefits
of using an environmentally friendly fuel as a marketing tool to obtain
greater brand awareness linked to the added benefit of being a good corporate
citizen. We anticipate that this program will gain the most traction in those
states, such as California, Texas and Nevada that mandate the use of
clean-burning alternative fuels. Brazil: In Brazil, O2Diesel plans to target customers similar to those in the U.S. We
have established our own sales and technical capabilities in Brazil to
substantially mirror what has been done in the U.S. In addition, we have joined
with a Brazilian commodity firm that trades sugar and alcohol for the purpose
of obtaining local assistance to introduce our products into the
Brazilian market This Brazilian commodity firm owns 25% of O2Diesels
Brazilian subsidiary. Together with our equity partner, we have targeted some
of Brazils largest sugar growers and millers as potential customers for
O2Diesel. We also intend to market our fuel to municipalities and large
fleets in Brazil using environmental initiatives similar to those we are
designing for use in the U.S. and Canadian markets. Brazils fuel distribution system is more concentrated than the fuel
distribution network in the U.S. As a consequence, O2Diesel must join with one
or more large fuel distributors who can deliver and distribute O2Diesel in
Brazil. Failure to attract distribution partners would likely set back our
timetable for achieving market penetration in Brazil. Potential distribution
partners have been identified but discussions are in the preliminary stages,
and, as of the date of this report, there can be no assurance that we will
reach a definitive agreement with any of these companies. Penetration of the Brazilian market has been slower than planned. As of the
end of September 2004, we had only one customer using the fuel on a trial
basis. This customer is one of the largest producers of sugar and ethanol in
Brazil Cash Requirements and Liquidity: Based on our current projected level of operations and expected sales, we will
need to raise additional funds by the end of the first quarter of 2005. In the
first quarter of 2004, we completed two financings in which the Company issued
newly-created preferred stock in exchange for approximately $5.5 million in net
proceeds. These funds were received in March and May of 2004. In addition,
during the first quarter of 2004, we received net proceeds of approximately
$536,000 in a private placement of shares of our common stock. As of March 31,
2004, the Company closed the private placement and had a subscription
receivable of approximately $230,001 as of that date. Subsequent to March 31,
2004, we collected gross proceeds of $50,001 and wrote off the remaining
balance of $180,000 in the subscription receivable account because the
subscriber elected to not purchase the shares. To date, we have not had any bank trade facilities, except an overdraft line in
the U.K. used to meet operating needs. This overdraft facility was repaid and
canceled during 2003. 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. The Company has favorable trade terms with
Cognis for the supply of additive. Under these terms, we expect to be able to
purchase and sell our additive product and match the receipt of sales proceeds
with payment for our additive inventory. Significant technical and logistical issues continue to affect our ability to
generate sales, and these issues have led to a need to raise additional funds
for working capital. First, as part of the process by which O2Diesel was
approved for sale in California, the California Air Resources Board (CARB) set
a number of conditions that must be adhered to on an ongoing basis. One of the
conditions is that all storage tanks in which O2Diesel is stored and all
vehicles that use the fuel must be
fitted with devices known as flame arrestors. Flame arrestors are safety
devices which are intended to prevent a fire in the case that a spark or other
type of ignition might inadvertently enter the fill inlet of a fuel tank. This
is a serious issue and has negatively impacted the Companys ability to
efficiently commercialize its products in the U.S. Even though flame arrestor
technology has been used for many years in other applications, flame arrestors
in the required sizes and designs are not yet 3




---



##### 



O2Diesel Corporation
(A Development Stage Company)
September 30, 2004 available as an off the shelf item for use with O2Diesel. We are designing
flame arrestors for use with O2Diesel and these are now undergoing tests to
insure that they are capable of complying with all required specifications.
However, it now
appears that the costs of designing and fitting flame arrestors may be greater
than what we previously thought to be the case. Consequently, we have still
not obtained sufficient experience with sourcing, purchasing and fitting flame
arrestors to
vehicles and storage tanks to be able to accurately project the cost and time
of completing these tasks. Moreover, there is insufficient history for the
Company to be able to predict with certainty the manpower required to
accomplish this work. In addition, we have learned that certain vehicles
require the fitting of an auxiliary fuel pump to insure that the vehicle runs
properly in hot weather. These devices are simple and readily available and
the costs are known, but the necessity of adding these devices to certain
vehicles will increase our costs and is likely to increase the time required to
transition a fleet from using regular diesel fuel to the use of O2Diesel. Another concern relates to the logistics, storage and maintenance of O2Diesel
for fleets that use our fuel. To date, we have not completed the required
logistics arrangements to identify and finalize the best infrastructure to
insure that we can arrange for a supply of ethanol to blend with our additive
and then arrange for the timely delivery and proper storage of O2Diesel to
potential customers. In this regard, the Company has not fully completed the
necessary research and logistics studies to make certain the storage facilities
of users are capable of meeting the standards necessary to store and dispense
an ethanol based diesel fuel such as O2Diesel. As part of this on-going learning curve, 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 important that the
ethanol component of O2Diesel be of a consistently high quality and that it
meet certain other specifications. As part of the sales process, the Company
has initiated procedures to obtain samples of both the diesel fuel and ethanol
used to blend with our additive whenever a customer begins to use O2Diesel. Given our projected level of operating costs, the continuation of trade terms
from our major supplier and cash on hand as of the date of this report, we
expect to have sufficient cash to fund our operations for the remainder of
2004. However, because of the delays in our ability to procure flame arrestors
and because we have not been able to fully resolve all of the issues concerning
logistics, storage tanks and fuel grade ethanol, we must raise additional
funding by the end of the first quarter of 2005 if we are to have sufficient
operating capital to carry out our business plan. At the Companys Board of
Directors meeting in June 2004, our Board authorized management to raise
additional capital. We have begun the process to do so. In connection with
our efforts to attract new investment, there can be no assurance that we will
be successful in doing so. Nor can there be any assurance that the Company
will generate sales and collect cash to offset our operating expenses. During
the nine months ended September 30, 2004, the Company has generated only
$126,615 in product sales and has only minimal orders for either our additive
or O2Diesel. 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 the operations and cash
position of the Company. Research & Development: O2Diesel has an agreement with Cognis Deutschland GmbH (Cognis) for the joint
development of co-solvency additive products as well as the joint ownership of
patents covering such products. Under this agreement, O2Diesel has the
worldwide rights to market and sell the additive products and Cognis has the
worldwide rights to manufacture the additive. Under the terms of this
agreement, O2Diesel is not required to incur any research and development
expenditures, but we are required to share equally in the legal costs to file
all patent applications and to maintain all patents. We are responsible for the costs of testing our products. To date, these tests
have generally been specific to the jurisdictions in which we intend to do
business. For the remainder of 2004, we expect to pursue a program of testing
our products both in the laboratory and in field trials. In 2005 we plan to
carryout the necessary testing to obtain both CARB and EPA verifications for
the broadest possible array of engine families and uses. Other projected tests
include using O2Diesel in large mining operations within the United States.
Negotiations are underway with two large mining companies in the western United
States for each of them to use O2Diesel in selected mining equipment. Each
mine operator has given a favorable response to participating in a test
program, but additional planning is required to design the trials and to
develop the test protocols for each program. Almost all of the above tests,
which could cost as much as $2.0 million, are expected to be conducted within
the framework of existing grants received from the U.S. government. Based on
government funding that we have received and additional government funding that
we believe may be appropriated for these specific purposes, we 4




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##### 



O2Diesel Corporation
(A Development Stage Company)
September 30, 2004 estimate that as much as 80% of the costs for such laboratory tests and field
trials may be funded by U.S. government agencies such as the Department of
Energy and the Department of Defense. In addition to testing O2Diesel, the Company is continuing the process of
assisting in the design and testing of new flame arrestor technologies for a
wide range of vehicle applications. [For a more detailed explanation, see Note
3 to the Financial Statements on page F-8.] In Brazil, we expect to spend approximately $60,000 in 2004 on testing
protocols. The test protocols will be undertaken to insure that our additive
and resultant fuel complies with the governments fuel and environmental laws
and regulations. In addition, we expect that these tests will help to validate
the use of O2Diesel in the various types of vehicles and with different grades
of diesel fuel found in Brazil. Employees: At present, we have twenty full-time employees of which sixteen are in the U.S.
and four are in Brazil. For the remainder of the year, we plan to add three
full-time employees in the U.S. and one in Brazil, which would bring our total
employee count to twenty-four by the year-end. In the U.S., we plan to hire one
person for marketing support and two persons as field technical
representatives. In Brazil, we anticipate that the new employee would be in
technical sales. ITEM 3. CONTROLS AND PROCEDURES. EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES. O2Diesels Chief Executive
Officer and Chief Financial Officer have evaluated the effectiveness of
O2Diesels disclosure controls and procedures (as such term is defined in
Rules 13a-15 and 15d-15 under the Exchange Act) as of the end of the period
covered by this quarterly report (the Evaluation Date). Based on such
evaluation, such officers have concluded that, as of the Evaluation Date,
O2Diesels disclosure controls and procedures are effective in alerting them on
a timely basis to material information relating to O2Diesel required to be
included in its reports filed or submitted under the Exchange Act. CHANGES IN INTERNAL CONTROLS OVER FINANCIAL REPORTING. During the most recent
fiscal quarter, there have not been any significant 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 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS. On March 2 and March 12, 2004,the Company filed Certificates of Designation
with the Secretary of State of the State of Washington defining the rights of
holders of O2Diesel Series A and B 0% Convertible Preferred Stock, par value
$.0001 (Series A and B Preferred Stock). Pursuant to a Convertible Preferred
Stock Purchase Agreement between the Company and the purchaser named therein
(the Series A Purchaser) dated as of March 3, 2004, the Company issued to the
Series A Purchaser, 800,000 shares of Series A Preferred Stock. As initially contemplated, the Series A Preferred Stock was to be convertible
into the Companys common stock at a variable conversion ratio which is the
lesser of (a) $4.00 as adjusted as provided in the Series A Certificate of
Designation (the Series
A Fixed Conversion Price) or (b) eighty percent (80%) of the lowest closing
bid price for the Common Stock in the ten business days preceding the date of
conversion, but, in no case, less than 45.5% of the Series A Fixed Conversion
Price. In no event will the Series A Purchaser receive more than approximately
4,395,604 nor less than 2,000,000 shares of the Companys common stock upon
conversion of the Series A Preferred Stock. The Series A Preferred Stock is
subject to a two-year restriction on transfer. 5




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##### 



O2Diesel Corporation
(A Development Stage Company)
September 30, 2004 Pursuant to a Convertible Preferred Stock Purchase Agreement between the
Company and the purchaser named therein (the Series B Purchaser) dated as of
March 29, 2004, the Company issued to the Series B Purchaser, 600,000 shares of
Series B Preferred Stock and placed 150,000 shares in escrow. In May 2004,
the Company released the remaining 150,000 Series B Preferred shares to the
Series B Purchaser. As initially contemplated, the Series B Preferred Stock was to be convertible
into the Companys common stock at a variable conversion ratio which is the
lesser of (a) $3.65 as adjusted as provided in the Series B Certificate of
Designation (the Series B Fixed Conversion Price) or (b) eighty percent (80%)
of the lowest closing bid price for the Common Stock in the ten business days
preceding the date of conversion, but, in no case, less than 50% of the Series
B Fixed Conversion Price. In no
event will the Series B Purchaser receive more than approximately 4,109,589 nor
less than 2,054,795 shares of the Companys common stock upon conversion of the
Series B Preferred Stock. The Series B Preferred Stock is subject to a two-year
restriction on transfer. The sales of the Series A and B Preferred Stock were exempt from registration
pursuant to Regulation S promulgated under the Securities Act of 1933. Each of the Series A and B Preferred Stock certificates were amended in
September 2004 to change the floor conversion price and to change the terms
governing the sale and transfer of the shares. The changes are as follows: Changes to Series A Preferred Stock: The minimum price at which the Purchaser could convert the Series A Preferred
shares into our Common stock was set at forty-five and five tenths percent
(45.5%) of the Fixed Conversion Price of four dollars ($4.00). Thus, the
minimum price for conversion was one dollar and eighty-two cents. In
September 2004, we agreed to reduce the minimum conversion price to
twenty-seven and four tenths percent (27.4%) of the Fixed Conversion Price,
which now results in a minimum conversion price of one-dollar ($1.00). The
Purchase Agreement covering these shares was amended to add a provision which
prevents the Purchaser from converting the Series B Preferred Shares into
Common Stock for a period of two years (2) following the Closing Date of the
Transaction. Changes to Series B Preferred Stock: The minimum price at which the purchaser could convert the Series B Preferred
shares into our Common stock was set at fifty percent (50%) of the Fixed
Conversion Price of three dollars and sixty-five cents ($3.65). Thus, the
minimum price for conversion was one dollar and eighty-two and one-half cents
($1.825). In September 2004, we agreed to reduce the minimum conversion to
twenty-seven and four tenths percent (27.4%) of the Fixed Conversion Price,
which now results in a minimum conversion price of one-dollar ($1.00). The
Purchase Agreement covering these shares was amended to add a provision which
prevents the Purchaser from converting the Series B Preferred Shares into
Common Stock for a period of two years (2) following the Closing Date of the
Transaction. SUBSEQUENT CHANGES IN SECURITIES None ITEM 3. DEFAULTS UPON SENIOR SECURITIES. Not applicable. 6




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##### 



O2Diesel Corporation
(A Development Stage Company)
September 30, 2004 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. We held our annual general meeting on August 17, 2004 and the following matters
were submitted to a vote of the shareholders.  1.
    
    The election of six (6) persons as directors of the Company
to serve in three classes (Class A, Class B and Class C) having
staggered terms of three (3) years, or until their respective
successors shall have been duly elected and qualified;  a)
    
    Mr. Hendrik Rethwilm and Mr. Karim
Jobanputra were elected as Class A directors to hold
office until the 2005 annual meeting of stockholders.b)
    
    Mr. Richard Roger and Mr. David Koontz were
elected as Class B directors to hold office until the
2006 annual meeting of stockholders.c)
    
    Mr. Anthony Dean-Smith and Mr. Alan Rae were
elected as Class C directors to hold office until the
2007 annual meeting of stockholders.  Pursuant to its Bylaws, the Company is required to elect one class
of new directors at each annual general meeting. Directors serve
for a term of three years.2.
    
    The approval of an amendment to the Companys Bylaws to
increase the maximum size of our Board of Directors to 9
members from 6 members. Taking action to increase the size of
the Board was necessary in order to give the Company more
flexibility in complying with certain regulations of the
American Stock Exchange (AMEX) which requires that a majority
of the Board of Directors qualify as being independent as
defined by the AMEX.3.
    
    The change of the Companys state of incorporation from
Washington to Delaware. We believe that Delawares General
Corporation Law (DGCL) is the most extensive and well-defined
body of corporate law in the United States. Accordingly, we
believe that reincorporation under Delaware law will prove to be
beneficial to the Company because of the greater predictability of
the DGCL as well as the overall responsiveness of the states
legislature and courts to the needs of corporations organized in
Delaware.4.
    
    The adoption of the Companys 2004 Stock Incentive Plan. We
believe that the creation of a stock incentive plan is a necessary
part of the Companys long-term strategy to attract and retain key
employees who will be needed to develop and grow the business of
the Company.5.
    
    The ratification of the appointment of Ernst & Young LLP to
serve as the Companys independent auditors for the fiscal year
ending December 31, 2004.All of the above matters were adopted by the shareholders at the
annual general meeting held on August 17, 2004. The votes cast in
respect of the above matters are set forth in the following table: Votes Cast
    
    Rethwilm
    
    Jobanputra
    
    Roger
    
    Koontz
    
    Dean-Smith
    
    RaeFor
    
    
    9,823,667
    
    
    
    9,827,588
    
    
    
    9,828,988
    
    
    
    9,828,988
    
    
    
    9,828,988
    
    
    
    9,828,988Withhold
    
    
    0
    
    
    
    1,400
    
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    0Abstain
    
    
    2,000
    
    
    
    2,000
    
    
    
    2,000
    
    
    
    2,000
    
    
    
    2,000
    
    
    
    2,000Not Voted
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    0Total
    
    
    9,825,667
    
    
    
    9,830,988
    
    
    
    9,830,988
    
    
    
    9,830,988
    
    
    
    9,830,988
    
    
    
    9,830,988
 7




---



##### 



O2Diesel Corporation
(A Development Stage Company)
September 30, 2004 Increase
    
    Delaware
    
    Stock
    
    E & YVotes Cast
    
    Board (2)
    
    Corp (3)
    
    Plan (4)
    
    Auditor (5)For
    
    
    9,661,620
    
    
    
    9,112,681
    
    
    
    8,927,800
    
    
    
    9,829,988Withhold
    
    
    169,368
    
    
    
    0
    
    
    
    168,383
    
    
    
    1,000Abstain
    
    
    0
    
    
    
    0
    
    
    
    16,498
    
    
    
    0Not Voted
    
    
    0
    
    
    
    718,307
    
    
    
    718,307
    
    
    
    0Total
    
    
    9,830,988
    
    
    
    9,830,988
    
    
    
    9,830,988
    
    
    
    9,830,988
 ITEM 5. OTHER INFORMATION. On April 20, 2004 we signed a Supply and Distribution Agreement (Saudi
Agreement) with a Saudi Arabian company (Distributor) under which the
Distributor has been granted the exclusive rights for the sale and distribution
of the Companys additive and O2Diesel for three countries in the Middle East.
As part of the Saudi Agreement, the Distributor committed to order and take a
minimum amount of additive during each year of the Saudi Agreement, which by
its terms, is to continue for an initial period of five years with a right of
renewal by the Distributor for two successive three year terms. In the event
the Distributor failed to order and take delivery of the minimum amount
required under the Saudi Agreement, the Company may invoice the Distributor for
75% of the quantity by which the actual amounts fall short of the required
minimum. Since the execution of the contract, the Company has encountered
business and economic setbacks related to the contract that cause management to
challenge the value of the contract. The Company now believes it is unlikely
that this contract in its present form will have any value for the foreseeable future. The Company
does not expect to take any action to compel performance under this contract by
the Distributor. ITEM 6. EXHIBITS Exhibits Exhibits included or incorporated by reference in this document are set forth
in the Exhibit Index below. EXHIBIT INDEX 10.16
    
    Supply and Distribution Agreement between the Company and ALOBAYYA Corporation
dated April 20, 2004. (1)31.1
    
    Certification by Chief Executive Officer pursuant to Rule 13a-14(a) of the
Securities and Exchange Act of 1934, as amended (filed herewith)31.2
    
    Certification by Chief Financial Officer pursuant to Rule 13a-14(a) of the
Securities and Exchange Act of 1934, as amended (filed herewith)32.1
    
    Rule 13a-14(b) Certifications by Chief Executive Officer and Chief Financial Officer
pursuant to Rule 13a-14(b) the Securities and Exchange Act of 1934, as amended (filed herewith)99.5
    
    Articles of Amendment to the Certificate of Designation of the Rights and Preferences of
Series A 0% Convertible Preferred Stock of O2Diesel Corporation filed with the Secretary of
State of the State of Washington on September 15, 2004 (filed herewith)99.6
    
    Articles of Amendment to the Certificate of Designation of the Rights and Preferences of
Series B 0% Convertible Preferred Stock of O2Diesel Corporation
filed with the Secretary of State of the State of Washington on
September 10, 2004 (filed herewith)99.7
    
    Amendment to Convertible Preferred
Stock Purchase Agreement by and between O2Diesel Corporation and the
Purchaser named therein, dated as of September 1, 2004 (filed
herewith)99.8
    
    Amendment to Convertible Preferred
Stock Purchase Agreement by and between O2Diesel Corporation and the
Purchaser named therein, dated as of September 1, 2004 (filed
herewith)(1)
    
    Previously filed as Exhibit 16.3 to the Companys quarterly report on
Form 10-QSB for the quarter ended June 30, 2004 on August 13, 2004 and
incorporated herein by reference.
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##### 



O2Diesel Corporation
(A Development Stage Company)
September 30, 2004 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 12, 2004
    
    By: /s/ Alan RaeAlan RaeChief Executive Officer(Principal Executive Officer)Date: November 12, 2004
    
    By: /s/ David KoontzDavid KoontzChief Financial Officer(Principal Financial Officer)
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