Form
        10KSB
 
 O2DIESEL
        CORP - OTD
 
 Filed:
        March 27, 2007 (period: December 31, 2006)
 
 Annual
        report filed by small businesses
  
 
 Table
        of Contents
 
 PART
                  IItem
                  1.
              
              Description
                  Of BusinessItem
                  2.
              
              Description
                  of PropertyItem
                  3.
              
              Legal
                  ProceedingsItem
                  4.
              
              Submission
                  of Matters to a Vote of Security HoldersPART
                  IIItem
                  5.
              
              Market
                  for Common Equity and Related Stockholder MattersItem
                  6.
              
              Management’s
                  Discussion and Analysis or Plan Of OperationItem
                  7.
              
              Financial
                  StatementsItem
                  8.
              
              Changes In
                  And Disagreements with Accountants on Accounting and Financial
                  DisclosureItem
                  8A.
              
              Controls
                  and ProceduresItem
                  8B.
              
              Other
                  InformationPART
                  IIIItem
                  9.
              
              Directors,
                  Executive Officers, Promoters, Control Persons and Corporate Governance;
                  Compliance With Section 16(a) of the Exchange ActItem
                  10.
              
              Executive
                  CompensationItem
                  11.
              
              Security
                  Ownership of Certain Beneficial Owners and Management and Related
                  Stockholder MattersItem
                  12.
              
              Certain
                  Relationships and Related Transactions, and Director
                  IndependenceItem
                  13.
              
              ExhibitsItem
                  14.
              
              Principal
                  Accountant Fees and ServicesSIGNATURESEX-21
                  (EX-21)EX-31.1
                  (EXHIBIT 31.1)EX-31.2
                  (EXHIBIT 31.2)EX-32.1
                  (EXHIBIT 32.1)








O2Diesel
        Corporation


(A
      Development Stage Company)


**UNITED
      STATES SECURITIES AND EXCHANGE COMMISSION**


**WASHINGTON,
      D.C. 20549**




**FORM
      10-KSB**


(Mark
      one)


þ
            
            **Annual
                report under section 13 or 15(d) of the Securities Exchange Act of
                1934**




**For
      the fiscal year ended December 31, 2006**


**OR**


o
            
            **Transition
                report under section 13 or 15(d) of the Securities Exchange Act of
                1934**




**For
      the transition Period from _____________ to
      _____________.**




**Commission
      file number: 001-32228**


**O2Diesel
      Corporation**


(Name
      of
      small business issuer in its charter)




Delaware
            
            91-2023525(State
                or other jurisdiction of
            
            (I.R.S.
                Employerincorporation
                or organization)
            
            Identification
                No.)




100
                Commerce Drive Suite 301
              Newark,
                Delaware
            
            19713(Address
                of principal executive offices)
            
            (Zip
                Code)




Issuer’s
      telephone number: (302) 266-6000


Securities
      registered under Section 12(b) of the Exchange Act:




Name
                of exchange on(Title
                of Class)
            
            which
                registeredCommon
                Stock, $0.0001 par value
            
            The
                American Stock Exchange




Securities
      registered under Section 12(g) of the Exchange Act: Common Stock,
      None


(Title
      of
      class)




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.




Yesþ
            
            Noo




Check
      if
      there is no disclosure of delinquent filers in response to Item 405 of
      Regulation S-B is not contained in this form, and no disclosure will be
      contained, to the best of registrant’s knowledge, in definitive proxy or
      information statements incorporated by reference in Part III of this Form
      10-KSB or any amendment to this Form 10-KSB. o




Indicate
      by check mark whether the registrant is a shell company (as defined in
      Rule 12b-2 of the Act) Yes o No þ




State
      the
      aggregate market value of the voting and non-voting common equity held by
      non-affiliates computed by reference to the price at which the common equity
      was
      sold, or the average bid and asked price of such common equity, as of a
      specified date within the Past 60 days. (See definition of affiliate in Rule
      12b-2 of the Exchange Act.)




Registrant’s
      revenues for its most recent fiscal year :
      $250,934




The
      aggregate market value of the voting stock held by non-affiliates of the
      registrant on March 16, 2007 computed by the average bid and asked price as
      of March 16, 2007, at which the stock was sold, was $55,794,630, assuming
      solely for purposes of this calculation that all directors and executive
      officers of the issuer are “affiliates.” This determination of affiliate status
      is not necessarily a conclusive determination for other purposes.




On
      March 16, 2007, the registrant had 76,431,001 shares of common stock,
      $0.0001 par value per share, issued and outstanding.




TRANSITIONAL
      SMALL BUSINESS DISCLOSURE FORMAT: Yes o No þ


DOCUMENTS
      INCORPORATED BY REFERENCE


Documents
      incorporated by reference are listed in the Exhibit Index.







O2Diesel
      Corporation


(A
      Development Stage Company)


INDEX
      TO


ANNUAL
      REPORT ON FORM 10-KSB


FOR
      THE
      YEAR ENDED DECEMBER 31, 2006





PAGEPART
                IItem 1
                Description of Business
            
            
            4Item 2
                Description of Property
            
            
            11Item 3
                Legal Proceedings
            
            
            11Item 4
                Submission of Matters to a Vote of Security Holders
            
            
            11PART
                IIItem 5
                Market for Common Equity and Related Stockholder Matters
            
            
            11Item 6
                Management’s Discussion and Analysis or Plan of Operation
            
            
            15Item 7
                Consolidated Financial Statements
            
            
            22Item 8
                Changes In and Disagreements with Accountants on Accounting and Financial
                Disclosure
            
            
            22Item 8A
                Control and Procedures
            
            
            22Item 8B
                Other Information
            
            
            22PART
                IIIItem 9
                Directors, Executive Officers, Promoters, Control Persons and Corporate
                Governance; Compliance With Section 16(a) of the Exchange
                Act
            
            
            23Item 10
                Executive Compensation
            
            
            25Item 11
                Security Ownership of Certain Beneficial Owners and Management and
                Related
                Stockholders Matters
            
            
            29Item 12
                Certain Relationships and Related Transactions, and Director
                Independence
            
            
            31Item 13
                Exhibits
            
            
            31Item 14
                Principal Accountant Fees and Services
            
            
            33SIGNATURES
            
            
            34Exhibit Index
            
            
            31CERTIFICATIONS




2







NOTE
      REGARDING FORWARD LOOKING STATEMENTS




This
      annual report on Form 10-KSB contains forward-looking statements concerning
      O2Diesel Corporation (“O2Diesel,” the “Company” or the “Registrant”) and the
      Company’s 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 businesses.




O2Diesel
      cautions readers not to place undue reliance on any such forward-looking
      statements, which speak only as of the date made. Such forward-looking
      statements are based on the beliefs of O2Diesel’s management as well as on
      assumptions made by and information currently available to O2Diesel at the
      time
      such statements were made. Forward-looking statements are subject to a variety
      of risks and uncertainties which could cause actual events or results to differ
      from those reflected in the forward-looking statements, including, without
      limitation, the failure to obtain adequate financing on a timely basis and
      other
      risks and uncertainties. Actual results could differ materially from those
      projected in the forward-looking statements, as a result of either the matters
      set forth or incorporated in this report generally or certain economic and
      business factors, some of which may be beyond the control of O2Diesel. These
      factors include adverse economic conditions, entry of new and stronger
      competitors, inadequate capital, unexpected costs, failure to gain product
      approval in the United States or foreign countries for the commercialization
      and
      distribution of our products and failure to capitalize upon access to new
      markets and failure in obtaining the quality and quantity of ethanol necessary
      to produce our product at competitive prices. O2Diesel disclaims any obligation
      subsequently to revise any forward-looking statements to reflect events or
      circumstances after the date of such statements or to reflect the occurrence
      of
      anticipated or unanticipated events. “O2Diesel” and “CityHome” are trademarks of
      O2Diesel Corporation.




3




PART
      I





Item 1.
      Description Of Business




(a) Form
      and Year of Organization




O2Diesel
      Corporation (“O2Diesel” or the “Company”) is a development stage company 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 continue to be
      primarily focused on raising capital, performing product tests and
      demonstrations 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 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 consolidated financial statements of
      AAE
      are now treated as the historical financial statements of O2Diesel for all
      periods presented.





On
      June 15, 2004, the American Stock Exchange (“AMEX” or “Exchange”) approved
      an application to list 46,518,898 shares of our common stock under the symbol
      OTD. Subsequent to this date, the Exchange has approved additional applications
      to list 48,043,323 shares of the Company’s common stock so that the total number
      of shares approved for listing is now 94,562,221. Our shares began to trade
      on
      the exchange on July 1, 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.





The
      Company’s audited consolidated financial statements for the year ended
      December 31, 2006, have been prepared on a going concern basis, which
      contemplates the realization of assets and the settlement of liabilities and
      commitments in the normal course of business. At December 31, 2006, the
      Company has a working capital surplus of $6,637,669 but has accumulated losses
      of $33,086,440. Management has concluded that additional equity must be raised
      in 2007 in order for the Company to have sufficient cash to execute its business
      plan, and to be in compliance with the AMEX’s listing requirements.





As
      set
      forth in Part II, Item 5 of this report, management has stated that,
      as part of its 2005 plan submitted to and accepted by the AMEX, total equity
      of
      approximately $10.5 million, inclusive of the already completed
      $2.0 million, $3.0 million and $2.3 million private placements,
      would need to be raised in order for the Company to be in compliance with the
      listing standards of the AMEX by June 2006. In December 2005, the
      Company determined that it could not meet certain conditions of this plan and
      met with representatives of the AMEX to discuss the need to develop an amended
      plan to demonstrate how the Company would be in compliance by June 2006. In
      the amended plan developed by the Company, management indicated that if it
      were
      to be successful in raising $7.0 million prior to June 2006 and an additional
      $3.5 million in equity in the second half of 2006, it would have sufficient
      cash
      to execute its business plan through December 31, 2006, and to be in
      compliance with the listing standards of the AMEX by
      June 2006.





As
      described later in Part II, Item 5 of this report, the Company collected
      $592,692 (after expenses) and $865,452 (net of expenses) in two warrant
      exercises and closed three private placements totaling $7.5 million as part
      of
      this effort. The consolidated financial statements in this report do not include
      any adjustments to reflect other 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.





If
      the
      Company were to fail to return to full compliance with the Exchange’s listing
      standards, the AMEX would likely initiate procedures to de-list its common
      stock. If the Company’s common stock were to be de-listed by the AMEX, its
      shares would continue to be traded as a bulletin board stock.





On
      July
      17, 2006, the Company received a letter from the AMEX indicating that the
      Company had regained compliance with AMEX listing requirements. At December
      31,
      2006, the Company was in compliance with AMEX listing requirements. The Company
      believes that it will not be able to meet the AMEX listing requirements for
      equity as of the end of the first quarter of 2007. However, as described in
      the Subsequent Events section (Note 11 to the Financial Statements), the Company
      has entered into a common stock purchase agreement to raise up to $10 million
      in
      new equity in 2007, which we believe will enable us to meet or exceed these
      requirements, once the registration statement for such shares is
      effective.





Since
      July 2003, the Company has raised approximately $33 million for its
      operations.





(b) Business
      of O2Diesel




**Principal
      Products and Markets:**




O2Diesel
      has developed a proprietary additive product designed to improve the performance
      of distillate liquid transportation fuels by facilitating the addition to these
      fuels of ethanol, which is an oxygenate. More specifically, the Company’s core
      product, O2D05, is a fuel additive that can be made from soybean oil, other
      vegetable oils, or animal fats. The additive stabilizes and enhances the
      blending of
      fuel
      grade ethanol with diesel fuel. Blending O2D05 with ethanol and various grades
      of diesel fuel in turn creates a proprietaryclean
      burning fuel called O2DieselTM. Extensive testing in the laboratory and in real
      world trials has been carried out on O2D05 andO2DieselTM.
      These tests have demonstrated that the use of the fuel can produce significant
      and verifiable reductions in emissions. As an example, test data from a wide
      range of tests has shown the following reductions in harmful
      emissions:




Up
        to a
        70% reduction in visible smoke;


4




Up
      to a
      46% reduction in particulate matter (“PM”);




Up
      to a
      23% reduction in carbon monoxide;




Up
      to a
      6% reduction of oxides of nitrogen (“NOx”).





By
      way of
      background, fuel ethanol has been blended with gasoline for over 25 years
      in the U.S. and even longer in Brazil, with the combined benefits of improving
      air quality, reducing the use of petroleum based fuels and increasing the demand
      for agricultural products. Because of the incompatibility of diesel fuel and
      ethanol in a stand-alone environment, it has not been possible to combine
      ethanol and diesel fuel to produce a stable motor fuel. The Company’s additive,
      O2D05, permits diesel fuel to be blended with ethanol to produce a fuel that
      is
      suited for use by centrally fueled truck and bus fleets, off-road diesel
      equipment and other diesel powered machinery. However, some changes may be
      necessary to prepare vehicles and equipment to use the fuel, as well as to
      the
      storage and delivery systems used to dispense it.





The
      Company originally identified the U.S., Canada and Brazil as its first target
      markets, with an initial focus on the U.S. and Brazil. Since that time, the
      Company has developed additional strategic partnerships to expand its markets
      on
      a broader global basis. In 2007, we will continue to work with a large strategic
      partner in the ethanol industry to develop the European market for the Company’s
      products as well as an important supplier of alternative energy solutions and
      technology to develop the Asian market. O2Diesel’s strategy, with the support
      and resources of its commercial partners, is to create end-user demand from
      centrally fueled on and off-road diesel fleets, as well as large scale
      industrial operations that require significant diesel fuel supply, such as
      ports, mines and military installations.





Potential
      customers in the Company’s global markets include:





·
            
            Urban
                truck and delivery fleets;·
            
            Municipal
                transit authorities (public and private);·
            
            Government
                fleets (municipal, state, and federal);·
            
            Port
                logistical equipment;·
            
            Construction
                equipment;·
            
            Mobile
                or stationary power generators;·
            
            Railroads;·
            
            Military
                (non-tactical) vehicles.





The
      U.S.
      market for diesel fuel is large and growing. It has been estimated by the Energy
      Information Administration that the use of diesel fuel in the U.S. exceeds
      64 billion gallons per year and is expected to grow between 1-2% in 2007.





Basic
      to
      the success of the Company’s sales program is the availability of abundant
      supplies of fuel grade ethanol. According to statistics compiled by the
      Renewable Fuels Association, domestic ethanol plants in 2006 produced
      4.9 billion gallons of ethanol, an increase of 26% over 2005. At the end of
      2006, there were 114 plants producing ethanol with another 85 under construction
      or expansion, which, at completion, are expected to have an annual capacity
      of
      about 11.6 billion gallons. At present, the Company does not anticipate any
      supply problems in securing sufficient quantities of ethanol for use in the
      U.S.
      and Canada.




At
      the
      end of 2006, four customers in the U.S. and one customer in India were using
      the
      Company’s fuel either on a regular or on a trial basis. Typically, first-time
      users of O2DieselTM wanted to test the fuel in a small portion of their fleets
      before committing all of their vehicles to its use. These trials typically
      lasted for a period of three months or more and involved 10% or less of the
      vehicles in a prospective fleet.





In
      March 2004, O2Diesel began operations in Brazil through its 75% owned
      subsidiary, O2Diesel Químicos Ltda. Brazil is one of the pioneers in the use of
      ethanol and has a long history of manufacturing ethanol as a by-product from
      the
      production of sugar. Due to the low cost and availability of ethanol, Brazil’s
      transportation sector has used large amounts of this renewable fuel for the
      last
      three decades. Fuel ethanol has become an important fuel in Brazil due to its
      positive effects on the creation of jobs in the sugar industry and as a means
      of
      reducing the country’s dependence on imported diesel fuel, of which Brazil is a
      net importer. Moreover, both the Brazilian government and the sugar producers
      have sought various means to increase the demand for sugar and sugar
      derivatives.




5




The
      Company cooperates on a non-exclusive basis with Brazil’s largest fuel
      distributor, BR, the distribution arm of the state-owned mineral oil company
      Petrobrás. The Company has determined that, similar to the U.S., it must hire
      and train its own sales force to achieve meaningful sales in Brazil.





According
      to recently updated market studies, approximately 9 billion gallons of
      diesel fuel are consumed by Brazil’s transport sectors. As in the U.S. market,
      we initially targeted centrally fueled truck and bus fleets as our customers. Brazil
      experienced the same profile of testing by potential customers as that found
      in
      the U.S. During 2004, one sugar mill tested O2DieselTM in only a small portion of
      its truck fleet. In 2005, Brazil added an additional sugar mill customer, a
      municipal transit system and one waste fleet to its users of the fuel. During
      2006, the Company successfully concluded its demonstrations with the waste
      fleet
      and the transit fleet and the first sugar mill. At the beginning of 2007, we
      were continuing the work with the second sugar mill and were negotiating an
      additional demonstration with a large municipal transit fleet in Rio De
      Janeiro.





To
      summarize, the potential customers for O2DieselTM in Brazil include the
      following:





·
            
            Trucks
                — sugar / alcohol mills·
            
            Trucks
                — transport companies·
            
            Buses
                — large municipalities.





Later,
      our Brazilian subsidiary will seek to widen its market to include:




·
            
            Trucks
                — non-transport companies·
            
            Buses
                — intercity.





In
      Europe
      and Asia, our intial market focus will be on centrally fueled bus fleets and
      large trucking fleets.




In
      the
      U.S. and Canada, we expect to distribute our product, O2D05, directly to
      jobbers. “Jobbers” is a term in the fuel industry to describe companies that
      have a supply infrastructure that facilitates the purchase, blending, storage
      and delivery of fuel, which may include O2DieselTM. After purchasing our
      additive, jobbers will be responsible for all of the logistics necessary to
      blend the components to produce O2DieselTM. In most cases, they will purchase
      diesel and ethanol and blend these with our additive. At the time of sale of
      the
      O2DieselTM, the jobber will deliver the fuel using its own transportation fleet,
      common carriers or fuel trucks of its customer.





In
      Europe
      and Asia, we intend to distribute our product to large distributors who will
      operate under exclusive contracts covering specific geographic regions. As
      of
      December 31, 2006, we have entered into one distribution agreement in
      Asia.




In
      all
      our markets we also intend to have our sales force market O2DieselTM directly to
      large centrally fueled fleets of vehicles and equipment, where the user would
      typically have its own refueling infrastructure. In these cases, we must arrange
      for the delivery of O2DieselTM to the customer’s central fueling location. In
      limited situations, O2D05 by itself may be sold to large, central fleet
      customers, but in these cases, the customer must have the proper facilities
      to
      blend diesel fuel with fuel grade ethanol and additive. In most situations,
      we
      or the customer will contract with jobbers or other fuel transportation
      companies to blend and deliver the O2DieselTM.





To
      plan
      for the logistics necessary to deliver O2DieselTM, we are continuing our efforts
      to establish a reliable network of ethanol producers and providers of fuel
      transportation services. To
      that
      end, we have established supply relationships with twelve jobbers (fuel blending
      and distribution companies) and are negotiating supply agreements with ethanol
      distributors in order to obtain stable pricing for this commodity. Additional
      progress towards creating a network was achieved in 2006, but much needs to
      be
      done to arrive at the point where we have a seamless distribution network to
      serve our major markets.




For
      large
      centrally fueled fleets, the methods of distribution will be substantially
      the
      same for customers regardless of the market. However, the distribution of fuel
      in Brazil poses a potentially greater challenge than that in the U.S.,
      particularly due to legal restrictions imposed on the sales and distribution
      of
      ethanol and the structure of the fuel distribution markets. This
      occurs because there are only a few companies in Brazil that deliver petroleum
      fuels to the end user. As such, we have fewer choices from which to select
      partners in Brazil to establish an infrastructure for the distribution of our
      fuel.





**Competitive
      business conditions and position in the marketplace:**





In
      general, competition to O2Diesel’s technology may be split into three
      categories:





1.
            
            Ethanol-diesel
                blended fuel technologies (e-diesel);2.
            
            Exhaust
                after treatment technologies;3.
            
            “Other”
                fuels.




6




Within
      the first category, which comprises e-diesel fuel technologies, we believe
      there
      are a number of competitor companies that have or are attempting to develop
      fuel
      additives to compete with our technology. Based on limited market information,
      and even though some of the competing technologies are owned by larger and
      better financed corporations, it appears that none of the technologies are
      as
      advanced. Other cost effective diesel fuel additive technologies which would
      be
      expected to compete with our technology, such as metallic combustion improvers,
      are subject to significant regulatory issues that may affect their commercial
      viability. Various exhaust after treatment technologies are available in the
      marketplace to reduce emissions. Many of these technologies are designed for
      use
      on new vehicles, and, as such, may take several years to have an impact on
      emissions over a large vehicle population. In addition, these after treatment
      technologies may have higher implementation costs including the cost of vehicle
      retrofits, which may also be expensive. For this reason, we do not view exhaust
      after treatment technologies as being in direct competition to O2DieselTM. In
      2006, we began exploring testing these devices with our fuel to confirm whether
      additional benefits can be achieved when the two technologies are used together,
      such as reduced maintenance costs and enhanced control of emissions. Preliminary
      data indicates that after treatment technology is compatible and synergistic
      with our technology.





Ultra-Low
      Sulfur Diesel (“ULSD”) with and without bio-diesel have lower emissions than low
      sulfur diesel (“LSD”). Beginning in mid-2006, the diesel fuel specifications for
      the U.S. changed to require the use of ULSD for all on-highway use. ULSD is
      defined as having less than 15 parts per million sulfur. Combusting this low
      level of sulfur not only gives lower emissions but is necessary to allow current
      exhaust after treatment technologies to work effectively. ULSD is more expensive
      than regular diesel but is now supplied throughout the U.S. as a result of
      mandated change in the fuel specification. In 2005 and 2006, we demonstrated
      that our product not only works effectively with a base blend of ULSD, but
      also
      improves the lubricity elements of the base blend. In 2007, we are continuing
      to
      pursue a long-term strategy of working with refiners and distributors of ULSD
      as
      a means of broadening the market for both fuels - ULSD and O2DieselTM. Biodiesel
      is an ester containing hydrocarbon derived from renewable sources and blends
      of
      this component with ULSD is a viable alternative to ULSD alone. A blend of
      20%
      biodiesel in ULSD has been legislatively designated as an “EPACT fuel” and is
      used by the military to fulfill governmental requirements for reducing the
      use
      of petroleum. Biodiesel has had quality and some other drawbacks, among which
      can include cost, lack of availability, emission increases as well as handling
      and storage issues.





During
      2005 and 2006, we had one of our customers in our City HomeTM initiative
      successfully using a blend of biodiesel and O2DieselTM fuel. Our work with the
      Department of Defense has resulted in a new alternative fuel combining our
      additive technology, ULSD and biodiesel. In addition to our proprietary
      solubilizing agent and cetane improver, this fuel also has technology to improve
      the low temperature flow properties of the fuel which is necessary for cold
      temperature operation. This fuel with about 28% renewable components was
      performing as well as straight ULSD in an urban transit system at the end of
      2006. To our knowledge, it is the highest concentration of complementary
      renewable sourced components used for winter applications.





Below
      is
      a table which gives a brief overview of the advantages and disadvantages of
      the
      broad ranges of technologies that may be considered as competing with O2Diesel’s
      fuel technologies. This summary is not intended to be all-inclusive for
      competing technologies.





Lower
                EmissionsOptions
            
            Advantages
            
            DisadvantagesBio-diesel
            
            Renewable
                content, lower emissions andgovernmental
                incentives.
            
            Variable
                quality, availability, price, storage/handling
                & distributionExhaust
                Gas After
              Treatment
            
            Effective
                and an OEM hardware addition to meet 2007 model year vehicle emission
                needs
            
            High
                cost, owner resistance and maintenance issuesGas
                to Liquid & Fischer Tropsch
            
            Clean
                fuel and number of feedstock options
            
            High
                production cost, long lead time, priceHydrogen
                Gas/Fuel Cells
            
            Ultra
                clean vehicles
            
            Still
                at early research stageDiesel-Water
            
            Reduces
                both PM and NOx
            
            Poor
                fuel stability, reduced power





In
      Brazil, there are both domestic and foreign companies seeking to develop an
      ethanol diesel blending additive, but we believe that none of these potential
      competitors have perfected their respective technologies.




7




**Sources
      and availability of raw materials:**




O2Diesel
      has a cooperation agreement with Cognis Deutschland GmbH (“Cognis”) for the
      manufacture and marketing of the Company’s additive globally. Cognis has
      manufacturing facilities in or near each country in which we intend to sell
      our
      product. According to Cognis, these plants have sufficient capacity to produce
      enough product to allow us to meet our budgeted sales for the United States,
      India and Brazil for the next twelve months. Cognis has informed us that it
      does
      not anticipate there will be any shortages of raw material over the next twelve
      months. To date, Cognis has supplied all of the additive required.





**Dependence
      on one or a few major customers:**




At
      the
      end of 2006, the Company was still a development stage company and we reported
      additive sales of only $167,063 for the year. In 2007, we started the year
      with
      four North American customers and one Indian customer and have not reached
      the
      stage when we can start to develop a customer profile sufficiently large enough
      to allow us to affirmatively state that we will not be dependent on just one
      or
      even a few major customers. However, given the usage of diesel fuel in our
      target markets, U.S., Canada, Brazil, Europe and Asia, the drive of local and
      national governments to press for cleaner air legislation, and the mandates
      for
      our potential customers to comply with these legislative requirements, it is
      unlikely that we will be dependent in any of these markets on one or even a
      few
      large customers. Notwithstanding the foregoing, we have almost no sales history
      and cannot yet know for certain what our likely customer base will be or if
      one
      will develop at all.




Because
      of the many fuel distribution companies in the U.S. and Canada, it is unlikely
      that we will be dependent upon one or only a few large companies to distribute
      O2DieselTM. However, this may not be true for Brazil. For example, in Brazil, the
      country’s fuel distribution network is concentrated among a small number of
      large companies. Thus, it is possible, and perhaps likely, that we could become
      dependent on one or two large distributors for the sale of O2DieselTM in Brazil.
      O2Diesel cooperates on a non-exclusive basis with Brazil’s largest fuel
      distributor, BR, the distribution arm of the state-owned mineral oil company,
      Petrobrás. BR/Petrobrás is supplying readily blended O2Diesel fuel to the
      municipality of Rio de Janeiro.




In
      India,
      we have signed an exclusive agreement with one distributor for the market in
      that country. In Europe, we are exploring distribution agreements on a country
      by country basis.





**Patents/Trademarks:**




The
      Company has 109 patent applications covering eight different fuel and additive
      inventions relating to proprietary products registered with the international
      WIPO (PCT) Registration System. Four inventions currently have patents granted
      in a total of 32 countries in Europe, North America, Central America and Asia.
      An additional twelve applications relating to these inventions are pending.
      The
      other four inventions are either undergoing examination at the national level
      or
      are about to do so in various countries. If successful, these other four
      inventions could add up to 65 additional granted patents over the next two
      years. During this period, O2Diesel’s intellectual property rights over its
      additive products are protected through its registration with the WIPO (PCT)
      Registration System and its pending national patent applications.




As
      part
      of our cooperation agreement with Cognis, we, along with Cognis, are the joint
      owners of all patents covering both the use and composition of O2D05. All legal
      costs associated with preparing, filing and administering the jointly owned
      patents are shared equally by the Company and Cognis. We also have a number
      of
      patents that have been issued that relate to the predecessor technology of
      O2D05. As a strategic measure, we continue to fund all costs necessary to
      maintain some of these patents. O2Diesel is the sole owner of these latter
      patents, which in general cover the use and composition of its prior generation
      technology.




We
      have
      filed trademark registration applications in the U.S. and the European Union
      for
      a mark which includes the words and numbers O2Diesel as well as a figurative
      logo of the words.




We
      have
      continued our marketing initiative which is styled as CityHomeTM. On November 11,
      2004, we filed applications for the trademark “CityHome” (and design) in eight
      classes of goods and services. Final approval of the trademark was received
      in
      April, 2006. Applications were also filed for the trademarks “TODAY’S CLEAN AIR
      SOLUTION TOMORROW’S BRIGHTER FUTURE” and “CITYHO2ME” , each covering one class
      of goods and services. Final approvals of the trademarks were received in May
      2006.




**Government
      Approvals:**




In
      the
      U.S., O2DieselTM is subject to regulation at the federal, state and local levels.
      In addition, organizations such as the American Society for Testing &
Material (“ASTM”) and the National Conference on Weights & Measures (“NCWM”)
      set uniform industry product quality standards and test methods which are often
      adopted by legislative bodies and regulatory agencies.




These
      laws and regulations can and do change and these changes may favor or disfavor
      one product over another. This is particularly true in the case of incentives
      that are either available or are becoming available for the expanded use of
      cleaner-burning fuels like O2DieselTM or other emissions reduction
      technologies.




8




In
      the
      U.S., O2DieselTM is continuing the process to obtain regulatory approvals at
      various levels of government. At the federal level, the primary regulatory
      body
      from which the necessary approvals are required is the U.S. Environmental
      Protection Agency (“EPA”). The EPA requires the registration of all fuels for
      on-highway commercial use. The process of becoming a registered fuel for
      on-highway use is complex, costly and time-consuming. O2DieselTM has submitted
      emissions testing data and other required data as part of EPA’s Tier 1 fuel
      registration to demonstrate that O2 DieselTM does not generate
      additional air emissions as compared to diesel fuel. It is expected
      that EPA will complete its review and registration of O2DieselTM as a Tier 1
      atypical fuel during 2007. Tier 2 requirements are triggered if sales
      exceed $10 million in annual revenue. Tier 2 tests are intended to detect
      potential adverse health effects related to the inhalation of any additional
      emissions. The Company had previously registered its base additive (O2D05)
      with
      the EPA and has registered two other additive packages (O2D5000 and O2D5005).
      The latter package is more robust with respect to the fuel’s water tolerance at
      low temperatures. The Company received its first review questions from EPA
      for
      both this application and the blended fuel application and is working through
      the EPA’s responses with the agency.





States
      set strict requirements for the sale and distribution of motor fuels, and
      provide certain incentives for the use of cleaner-burning fuels. Certain states
      also levy disincentives for the use of “dirtier” fuels, often in the form of
      monetary penalties. With the exception of California and Texas, which are
      permitted to set stricter state standards, all state motor fuel environmental
      regulations are governed by EPA policies set forth in the Clean Air Act. In
      addition to environmental issues, many states have other regulations regarding
      the sale of fuel to which the Company may be subjected.





In
      2003,
      O2DieselTM achieved regulatory recognition (known as “verification”) in
      California granted by the California Air Resources Board (“CARB”) for O2DieselTM
as an “alternative diesel fuel,” thus making the fuel eligible for state and
      local incentives. During this same period, the Division of Measurement Standards
      (“DMS”) of the California Department of Food & Agriculture designated
      O2DieselTM as a “developmental engine fuel” which is a requirement for a fuel to
      be marketed legally in the state if it lacks a specification from a peer
      reviewed body such as ASTM. In 2006, the Company submitted several programs
      to
      complete the protocols to allow O2DieselTM to be classified as a Diesel Emissions
      Control Strategy (DECS) fuel by CARB. Given the base fuel changes, along with
      the Agency’s rule changes, O2Diesel has had to rework its original test plan. We
      are currently working through these issues, including Tier 1, Tier 2 and Tier
      3
      Multimedia Assessment. We expect to complete the necessary emissions testing
      and
      data generation to achieve DECS verification at as many levels as possible
      during 2007. Being a Verified Technology will allow O2Diesel to be competitive
      in this large market. As a condition to permitting the sale of O2DieselTM in
      California, CARB mandated, among other things, that in the case of storage
      or
      use of O2DieselTM, fuel storage tank vents, vehicle tank vents and fill openings
      must be fitted with flame arrestors.





In
      August
      2004, Nevada’s Division of Environmental Regulation approved O2DieselTM as an
“alternative fuel”. Nevada requires that state, county and municipal fleets of
      10 or more vehicles must use an alternative fuel rather than regular
      transportation fuels such as gasoline or diesel fuel.





Ethanol
      and diesel fuel blends do not have an ASTM specification. In 2006, a member
      of
      the Company became the Chairman of the E-Diesel subcommittee. This subcommittee
      submitted a specification for the purpose of proposing a ballot for
      incorporation of this fuel as an ASTM specification. The subcommittee received
      the initial results of this vote during the December, 2006 ASTM meeting and
      is
      currently working on a revised ballot based upon these comments. This new ballot
      is expected to be submitted to ASTM during the second quarter of 2007 so that
      it
      can be discussed and voted on during the June ASTM international meeting.





In
      Canada, there are fewer limits or restrictions on the introduction of new motor
      fuel products like O2DieselTM, despite the fact that the key federal regulatory
      agencies — Environment Canada and Natural Resources Canada — tend to follow the
      general policies set by the United States. One important quasi-governmental
      organization that serves a regulatory control function is the Canadian General
      Standards Board (“CGSB”), which works in a manner similar to ASTM. Fuels sold in
      Canada on a widespread basis will ultimately be subject to an industry and
      government consensus-based product specification. Across Canada and among the
      provinces, various tax and other incentives are in place to encourage the
      expanded production and use of biomass-based transportation fuels.





Various
      governmental approvals are required to sell O2DieselTM in Brazil. 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 O2DieselTM may
      be sold in Brazil. In 2004, we submitted applications to both agencies and
      received limited, but favorable approvals from each. ANP has classified
      O2DieselTM as an alternative diesel fuel. In addition, IBAMA, approved O2DieselTM
for off road (e.g. in mining) and railroad applications. Also, in response
      to
      requests that we submitted to ANP, it granted approval for O2DieselTM to be sold
      to specific customers and for specific regions in Brazil.





In
      Europe, the regulatory environment surrounding alternative fuels is largely
      centered on biodiesel. Since ethanol-diesel is a new technology in the European
      Union, the Company is working on a country by country basis to better define
      e-diesel regulatory requirements and how they can be supplemented by changes
      to
      the existing regulatory structure. Like in the United States, alternative fuels
      are allowed for individual test demonstrations in most European countries,
      but
      must be approved by the country’s appropriate governmental agency on a
      case-by-case basis.




9





In
      India,
      the Company sells its base additive directly to its exclusive distributor for
      this market. The distributor bears the responsibility for blending the final
      e-diesel product and to fulfill the local and national regulatory requirements
      needed to market the final product.





**Effect
      of existing or probable governmental regulations:**




Regulations
      may affect new motor fuel products by raising barriers to entry (thus keeping
      out untested products that lack proof of claims for performance) or by providing
      incentives for products that help achieve public policy goals. O2DieselTM began
      an intensive engine and fleet testing program in 1999 which will continue
      through 2007. This testing is designed to provide proof to federal, state and
      local regulatory bodies as well as to the U.S. military that O2DieselTM has a
      positive impact in reducing emissions that contribute to ground-level ozone
      in
      urban areas, and that it will reduce toxic particulate matter emissions. Some
      of
      these agencies may provide incentives for the use of such products in cases
      where the benefits of using the products can be verified.




Regulations
      for motor fuels may have the effect of limiting competition from products that
      cannot prove their claims to regulators, while giving others that can an
      advantage in the marketplace. Moreover, the availability of federal, state
      and
      local incentives to encourage the use of verified products may make O2DieselTM a
      cost-effective fuel for fleets seeking to comply with tougher new air quality
      regulations. As an example of these incentives, the U.S. government permits
      a
      credit against excise tax for ethanol blended with diesel fuel. In prior years,
      this incentive was computed differently, was more complex and was subject to
      a
      number of limitations, the most significant being that it did not apply to
      ethanol diesel blends used in off-road vehicles and equipment.





On
      October 22, 2004, President Bush signed into law the American Jobs Creation
      Act of 2004 (P.L. 108-357). This new law made important changes to the existing
      law by allowing a refundable excise tax credit for ethanol blended with diesel
      fuel. The new law, which is called the “Volume Ethanol Excise Tax Credit”
(VEETC) extends the credit through December 31, 2010. Generally, it
      provides that a credit may be taken at $0.51 per gallon for ethanol blended
      with
      diesel fuel used for both on-road and off-road applications. O2DieselTM, when
      blended with the appropriate ethanol, qualifies for this excise tax
      credit.




The
      Company is not aware of any incentives for the use of its additive or fuel
      in
      Brazil and is in the process of exploring Europe and Asia for available
      incentives.




The
      Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley Act”) comprehensively revised the
      laws affecting corporate governance, accounting obligations and corporate
      reporting for companies, such as O2Diesel, with equity or debt securities
      registered under the Securities and Exchange Act of 1934, as amended (the
“Exchange Act”). In particular, the Sarbanes-Oxley Act established: (1) new
      requirements for audit committees, including independence, expertise, and
      responsibilities; (2) requirements with respect to the establishment and
      evaluation of disclosure controls and procedures and internal control over
      financial reporting, and the audit of internal control over financial reporting;
      (3) additional responsibilities for the Chief Executive Officer and Chief
      Financial Officer of the reporting company with respect to financial statements
      and other information included in Exchange Act reports; (4) new standards
      for auditors and regulation of audits; (5) increased disclosure and reporting
      obligations for the reporting company and its directors and executive officers;
      and new and increased civil and criminal penalties for violations of the
      securities laws. The Company will be subject to additional compliance provisions
      of the Sarbanes-Oxley Act beginning  in 2008 regarding internal control
      over financial reporting and the audit of internal control over financial
      reporting.





**Estimate
      of the amount of time spent during each of the last two fiscal years on research
      and development activities:**




O2Diesel
      has an agreement with Cognis for the joint development of co-solvency additive
      products as well as the joint ownership of patents covering such products.
      Under
      the terms of this agreement, O2Diesel is not required to devote time or incur
      any research and development expenditures for the work performed by Cognis,
      but
      we are required to share equally in the legal costs to prepare, file and
      maintain all joint patent applications and issued patents. See section below
—
Costs and effects of complying with environmental laws.





**Costs
      and effects of complying with environmental laws:**




O2Diesel
      is faced with very few costs for it to comply with environmental laws and
      regulations. However, we have 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. In the case of O2DieselTM, many of the tests
      required by the U.S. government have been funded by governmental appropriations.
      More specifically, in 2006, we incurred expenses of approximately
      $1.9 million 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.
      For a more detailed description of government appropriations, see Note 3 to
      the
      Financial Statements.





At
      the
      start of 2007, the Company had government test programs in progress with total
      remaining costs of approximately $1.2 million. A wide array of tests and
      product demonstrations are being carried out under these programs.





Included
      are product demonstrations in Nevada to test O2DieselTM in non-tactical military
      equipment, and in California to use O2DieselTM in a fleet of refuse trucks. Other
      test programs underway include completing the protocols to allow O2DieselTM to be
      classified as a Diesel Emissions Control Strategy fuel by the California Air
      Resources Board. O2Diesel is conducting demonstrations with a number of school
      bus and transit agencies testing O2DieselTM as well as O2DieselTM blended with B20
      in various weather conditions, engine types, and uses. Still other tests will
      include using O2DieselTM in mining equipment as well as seeking to obtain a
      military procurement specification for the fuel. Based on the government funding
      in place, we believe that approximately 80% of the costs
      to
      conduct all of these tests may be funded by appropriations from the U.S.
      Departments of Energy and Defense.




10




In
      2006,
      we spent about $3,300 in Brazil for research and development projects and to
      obtain approvals for O2DieselTM from the agencies that are responsible for the
      country’s petroleum industry and environmental laws. Brazil’s environmental
      agency, IBAMA, has classified O2DieselTM as an alternative diesel fuel, and ANP,
      Brazil’s national petroleum agency, has granted approvals in specific cases for
      the sale and use of O2DieselTM.




For
      2007,
      we do not anticipate spending any funds on various product and vehicle tests
      in
      Brazil with regard to environmental laws.





**Employees:**




O2Diesel
      has seventeen full-time employees, sixteen of which are in the U.S. and one
      is
      in Europe. We have one part-time employee. During this past year, we have relied
      on consultants to assist in commercializing our technology and to help us in
      key
      technical areas. We expect to continue this practice in 2007. At present, we
      employ eight consultants in the U.S.; four in marketing and business
      development; one field technician, one laboratory technician, one chemist;
      and
      one in regulatory affairs. The Company has entered into separate consulting
      contracts with two shareholders of its Brazilian subsidiary for the purpose
      of
      providing office rent and administrative services and in lieu of employment
      contracts with these two individuals. In Europe, we employ two consultants,
      one
      for general management and business development and one for regulatory affairs.





We
      will
      add new personnel in 2007 based on the pace of our commercialization. Under
      our
      business plan, we do not see the need to add employees in the U.S. or Brazil,
      but we do plan to add technical positions for our European market testing and
      development in 2007. We anticipate continuing to employ a total of twelve
      consultants serving in most of the same capacities in 2007.





**(c) Reports
      to Security Holders:**




We
      file
      annual and quarterly reports, proxy statements and other information with the
      SEC. You may read and copy any document we file at the SEC’s Public Reference
      Room at 100 F Street, N.E., Washington D.C. 20549. Please call the SEC at
      1-800-SEC-0330 for further information on the public reference room. The SEC
      maintains a website at http://www.sec.gov that
      contains reports, proxy and information statements and other information
      concerning filers. We also maintain a web site at http://www.O2Diesel.com that
      provides additional information about our company and links to documents we
      file
      with the SEC.





Item 2.
      Description of Property





O2Diesel
      owns no real property. We rent 4,950 square feet of office space located at
      100
      Commerce Drive, Suite 301, Newark, Delaware, 19713, under a five-year lease
      entered into in December 2003. This space serves as the corporate
      headquarters of the group. The aggregate cost of this office space over the
      lease term is $392,875, plus common area charges that are billed monthly to
      the
      Company. We also have a small laboratory of about 2,500 square feet in
      Wilmington, Delaware, rented under a twelve month lease for $1,195 per month,
      which expires November 30, 2007.





In
      July 2005, we entered into a month to month lease for office space of about
      650 square feet in Sao Paulo, Brazil, which can be cancelled with a thirty
      day
      notice at a cost of about $900 per month. In addition, the offices in Rio and
      Curitiba were closed in July 2005.




In
      September 2006, we entered into a one year lease for office space of
      approximately 300 square feet in Brussels, Belgium at a cost of 2,240€ per
      month.





We
      own
      office furniture and equipment costing approximately $206,000 and test and
      fuel
      storage equipment costing approximately $213,000.





During
      2006, there were approximately $93,600 in additions of test equipment and
      $44,150 to office furniture and equipment consisting of furniture, computers
      and
      related equipment. On November 4, , 2004,
      the Company had purchased a diesel truck to be used for product testing and
      analysis. The cost of this vehicle was $26,545. Subsequent to this purchase
      the
      Company had financed $23,000 of the purchase price with a bank. The loan was
      secured by the truck. The note bore interest at 7.00% and was payable in
      24 monthly installments of $1,031 with the final payment due in November
      2006. The Company disposed of the truck in November 2005 and received
      proceeds of $11,900, which were used to pay off the balance of the
      loan. In
      February 2006, the Company purchased a used truck and outfitted it to be able
      to
      provide mobile fueling to equipment at an NREL project in Wyoming. The truck
      had
      a cost of $28,813 and has $5,042 of accumulated depreciation as of December
      31,
      2006.





Item 3.
      Legal Proceedings




O2Diesel
      is not a party to any legal proceedings as of the date of this report.





Item 4.
      Submission of Matters to a Vote of Security Holders




No
      matters were submitted to a vote of the stockholders through solicitation of
      proxies or otherwise during the fourth quarter of the year ended
      December 31, 2006.





PART
      II





Item 5.
      Market for Common Equity and Related Stockholder Matters





**Market
      Information:**




O2Diesel’s
      common stock is traded on the American Stock Exchange (AMEX) under the symbol
      “OTD”.




11




The
      following table sets forth, for the periods indicated, the range of the high
      and
      low sale prices for O2Diesel’s common stock:


Quarter
                  Ended
              
              High
                  (1)
              
              Low
                  (1)December 31,
                  2006
              
              $
              0.91
              
              $
              0.68September 30,
                  2006
              
              
              1.28
              
              
              0.78June 30,
                  2006
              
              
              2.82
              
              
              0.92March 31,
                  2006
              
              
              0.87
              
              
              0.40December 31,
                  2005
              
              
              0.87
              
              
              0.37September 30,
                  2005
              
              
              1.42
              
              
              0.76June 30,
                  2005
              
              
              1.91
              
              
              1.20March 31,
                  2005
              
              
              2.10
              
              
              0.74




Source
      of
      Information: Yahoo Finance





**Holders
      of Common Equity:**




As
      of
      March 16, 2007, there were 76,431,001 shares of our common stock
      outstanding, held by approximately 9,250 stockholders of record.





**Dividends:**




To
      date,
      we have not paid any dividends on our common stock and we do not expect to
      declare or pay any dividends on our common stock in the foreseeable future.
      Payment of dividends will depend upon our future earnings, if any, our financial
      condition, and other factors as deemed relevant by the Board.




**AMEX
        Listing Standards:**
 
 In
        December 2004, we were notified by the AMEX that O2Diesel was not in
        compliance with the Exchange’s listing standards. Specifically, because of
        continuing losses and the fact that our shareholders’ equity had fallen below
        $2.0 million, we had failed to meet the required listing
        standards.
  In
        accordance with the procedures of the Exchange, we filed a plan (“Plan”) with it
        to demonstrate the steps we had to take to return to full compliance. On
        February 15, 2005, the AMEX notified us that it had accepted our Plan, and
        that we would be given until June 2006 in which to regain compliance with
        the Exchange’s listing standards. During this period, we were subject to
        periodic reviews by the AMEX to confirm that we were meeting the goals set
        forth
        in our Plan. As of June 2006, our shareholders’ equity was required to be
        $6.0 million or more in order for us to be in compliance with the
        Exchange’s listing rules. To achieve that amount, we anticipated having to raise
        a total of approximately $10.0 million in new equity during 2005. In
        December, 2005, the Company determined that it could not meet certain conditions
        of this plan and met with representatives of the AMEX to discuss the need
        to
        develop an amended plan to demonstrate how the Company would be in compliance
        by
        June, 2006. In the amended plan developed by the Company, management indicated
        that if it were to be successful in raising $7.0 million prior to June, 2006
        and
        an additional $3.5 million in equity in the second half of 2006, it would
        have
        sufficient cash to execute its business plan through December 31, 2006, and
        to be in compliance with the listing standards of the AMEX by
        June 2006.
  As
        described later in this section, the Company collected $592,692 (after expenses)
        and $865,452 (net of expenses) in two warrant exercises and closed three
        private
        placements totaling $7.5 million as part of this effort. The consolidated
        financial statements in this report do not include any adjustments to reflect
        other 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.
  If
        the
        Company were to fail to return to full compliance with the Exchange’s listing
        standards, the AMEX would likely initiate procedures to de-list its common
        stock. If the Company’s common stock were to be de-listed by the AMEX, its
        shares would continue to be traded as a bulletin board stock. On July 17,
        2006,
        the Company received a letter from the AMEX indicating that the Company had
        regained compliance with AMEX listing requirements.
  On
        December 31, 2006, the Company was in compliance with AMEX listing standards. The Company believes that it will not be able to meet
        the
        AMEX listing requirements for equity as of the end of the first quarter of
        2007. However, as described in the Subsequent Events section (Note 11 to
        the
        Financial Statements), the Company has entered into a common stock purchase
        agreement to raise up to $10 million in new equity in 2007, which we believe
        will enable us to meet or exceed these requirements, once the registration
        statement for such shares is effective.


12




**Recent
      Sales of Unregistered Securities over the past three years:**





**Follow-On
      Private Placement:**




Subsequent
      to its first private placement in 2003, the Company undertook to raise an
      additional $3.5 million through a follow-on private placement of our common
      stock (the “Follow-On Private Placement”). In the Follow-On Private Placement,
      we raised $1,535,770, before expenses, and issued 1,025,784 shares of our common
      stock at a price of $1.50 per share. The Follow-On Private Placement was closed
      on March 31, 2004. There was no underwriter involved in the Follow-On
      Private Placement. Sales of common stock under the Follow-On Private Placement
      that were completed in non-U.S. transactions were exempt from registration
      pursuant to Regulation S promulgated under the Securities Act of 1933, as
      amended (the “Securities Act”). The sales of common stock under the Follow-On
      Private Placement to accredited U.S. investors were exempt pursuant to
      Regulation D promulgated under the Securities Act.




**Series A
      0% Convertible Preferred Stock Private Placement**




Pursuant
      to a Convertible Preferred Stock Purchase Agreement between the Company and
      the
      purchaser named therein (the “Series A Purchaser”) dated as of
      March 3, 2004, the Company issued to the Series A Purchaser, 800,000
      shares of Series A 0% Convertible Preferred Stock, par value $.0001
      (“Series A Preferred Stock”). The offering resulted in gross proceeds of
      approximately $3,200,000 to the Company, prior to the deduction of fees and
      commissions. The sale of the Series A Preferred Stock was exempt from
      registration pursuant to Regulation S promulgated under the Securities Act. The
      Series A Preferred Stock was initially convertible into the Company’s
      common stock at a variable conversion ratio which was the lesser of (a) $4.00
      as
      adjusted as provided in the Series A Certificate of Designation (the
“Series A Fixed Conversion Price”) or (b) eighty percent (80%) of the
      lowest closing bid price for the Common Stock in the ten business days preceding
      the date of conversion, but, in no case, less than 50% of the Series A
      Fixed Conversion Price. In September 2004, we renegotiated the conversion
      formula with the holder of these shares. Now the minimum price at which the
      shares may be converted is equal to twenty-five percent (25.0%) of the Fixed
      Conversion Price, or $1.00 per share. Pursuant to the amended agreement, the
      Series A Purchaser may not convert Series A Preferred Stock into our
      common stock for a period of two (2) years following the closing date of
      this transaction. Under the revised agreement, in no event will the
      Series A Purchaser receive more than 8,000,000 or less than 2,000,000
      shares of the Company’s common stock upon conversion of the Series A
      Preferred Stock.




The
      Series A Purchaser was granted an option to purchase additional shares of
      the Company’s common stock equal to the difference between the number of shares
      of common stock actually received upon conversion and the number of shares
      that
      would have been received at a conversion price of $1.82. The exercise price
      shall be the Series A Fixed Conversion Price.




**Series B
      0% Convertible Preferred Stock Private Placement**




Pursuant
      to a Convertible Preferred Stock Purchase Agreement between the Company and
      the
      purchaser named therein (the “Series B Purchaser”) dated as of
      March 29, 2004, the Company issued to the Series B Purchaser, 750,000
      shares of Series B 0% Convertible Preferred Stock, par value $.0001
      (“Series B Preferred Stock”). The offering resulted in gross proceeds
      of approximately $3,000,000 to the Company, prior to the deduction of fees
      and
      commissions. The sale of the Series B Preferred Stock was exempt from
      registration pursuant to Regulation S promulgated under the Securities
      Act.




The
      Series B Preferred Stock was initially convertible into the Company’s
      common stock at a variable conversion ratio which was the lesser of (a) $3.65
      as
      adjusted as provided in the Series B Certificate of Designation (the
“Series B Fixed Conversion Price”) or (b) eighty percent (80%) of the
      lowest closing bid price for the Common Stock in the ten business days preceding
      the date of conversion, but, in no case, less than 50% of the Series B
      Fixed Conversion Price. In September 2004, we renegotiated the conversion
      formula with the holder of these shares. Now the minimum price at which the
      shares may be converted is equal to twenty-seven and four tenths per cent
      (27.4%) of the Series B Fixed Conversion Price, or $1.00 per share.
      Pursuant to the amended agreement, the Series B Purchaser may not convert
      Series B Preferred Stock into our common stock for a period of two
      (2) years following the closing date of this transaction. Under the revised
      agreement, in no event will the Series B Purchaser receive more than
      7,500,000 or less than 2,054,795 shares of the Company’s common stock upon
      conversion of the Series B Preferred Stock.




The
      Series B Purchaser was granted an option to purchase additional shares of
      the Company’s common stock equal to the difference between the number of shares
      of common stock actually received upon conversion and the number of shares
      that
      would have been received at a conversion price of $1.82. The exercise price
      shall be the Series B Fixed Conversion Price.





In
      April
      2006, the holders of both the Series A and Series B Convertible Preferred Stock
      exercised all of their conversion rights and converted 1,550,000 shares of
      Convertible Preferred Stock into 15,500,000 shares of common stock.




13




**** **$2.0
      and $3.0 Million Private Placements**




In
      a
      series of two private placements of the Company’s common stock in 2005, the
      Company raised $4,833,192 after payment of an 8% commission and other expenses,
      and issued 7,535,981 shares of common stock at a price of $0.70 per share.
      Subscribers to this private placement received for each two shares of common
      stock purchased one warrant to purchase one additional share of common stock.
      The warrant expires twenty-four months following the closing of the private
      placement. Each warrant is exercisable at a price of $0.70 per share during
      the
      first twelve months following the close of the private placement, or at an
      exercise price of $1.05 per share in the second twelve months following the
      close the private placement. The total number of warrants issued was 3,757,990.
      The common stock and the warrants were issued to the accredited investors in
      a
      transaction that will be exempt from registration pursuant to Section 4(2)
      of
      the Securities Act, and/or Regulation D promulgated under the Securities
      Act.





**$2.3
      Million Private Placement**




On
      October 24, 2005, the Company issued 3,228,070 shares of common stock at a
      purchase price of $0.7125 per share in a private placement for total proceeds
      of
      $2,300,000.





As
      part
      of this sale, the Company also issued warrants to purchase 1,614,035 shares
      of
      common stock at an exercise price of $1.425 per share during the period of
      six
      months to forty-two months subsequent to issuance or at a cashless exercise
      if a
      registration statement is not effective within one year of issuance. The
      warrants expire forty-two months after the date of issuance.





As
      part
      of the transaction, the Company agreed to sell up to an additional $700,000
      of
      its common stock to the Purchaser at a purchase price of $0.7125 per share
      for
      982,456 shares. The Company also issued warrants to purchase 491,228 shares
      of
      common stock at an exercise price of $1.425 per share during the period of
      six
      months to forty-two months subsequent to issuance or at a cashless exercise
      if a
      registration statement is not effective within one year of issuance. The
      warrants expire forty-two months after the date of issuance. The purchaser
      had
      180 days following the date of the Purchase Agreement to acquire additional
      shares. This offer expired unexercised on March 20, 2006.





The
      Company agreed to issue warrants to purchase 1,614,035 shares of common stock
      at
      an exercise price of $0.7125 per share to its advisor in connection with this
      transaction. The warrants expire forty-two months after the date of issuance.
      The common stock and the warrants were issued to the accredited investor in
      a
      transaction that will be exempt from registration pursuant to Section 4(2)
      of
      the Securities Act, and/or Regulation D promulgated under the Securities
      Act.





**$3.6
      Million Private Placement**




On
      December 16, 2005, the Company issued 6,419,840 shares of the Company’s common
      stock in a private placement, for total proceeds of 3,000,000€, or approximately
      $3.6 million at the then current exchange rates.





As
      part
      of the transaction, the Company issued warrants to purchase 2,853,262 shares
      of
      common stock at an exercise price of $0.85 per share during the period six
      to
      forty two months subsequent to the date of issuance or at an exercise price
      of
      $1.13 per share during the period forty three to sixty six months after the
      date
      of issuance. The warrants expire sixty six months after the date of issuance.





**$4.0
      and $2.5 Million Private Placements** ****




On
      April
      6, 2006, the Company entered into a Common Stock and Warrant Purchase Agreement
      (“$4.0 million Purchase Agreement”) with a UK investor (the “Investor”) for
      5,333,333 shares of common stock at a purchase price of $0.75 per share in
      a
      private placement for total proceeds of $4,000,000 (the “$4.0 million Private
      Placement”). As part of this sale, the Company also issued warrants to purchase
      2,666,667 shares of common stock at an exercise price of $0.825 per share during
      the period of six months to forty-two months subsequent to issuance. The
      warrants expire forty-two months after the date of issuance. The Investor's
      obligation to purchase the shares was subject to the Company satisfying certain
      additional conditions.





Also
      on
      April 6, 2006, the Company entered into a Common Stock and Warrant Purchase
      Agreement (“$2.5 million Purchase Agreement”) with a different European
      investor (the “2 nd Investor”) for 3,333,333 shares of common stock at a purchase price of $0.75 per
      share in a private placement for total proceeds of $2,500,000 (the “$2.5 million
      Private Placement”) before payment of a 9% commission and other expenses. As
      part of this sale, the Company also issued warrants to purchase 1,666,667 shares
      of common stock at an exercise price of $0.825 per share during the period
      of
      six months to forty-two months subsequent to issuance. The warrants expire
      forty-two months after the date of issuance. The 2 nd Investor's obligation to purchase the shares was subject to the Company
      satisfying certain additional conditions.





Subsequent
      to entering into these agreements, the Company entered into an identical
      amendment to each agreement which (i) modified the amount of liquidated damages
      to a maximum of 8% of the purchase price and (ii) added that shareholder
      approval will be obtained prior to the Company issuing the shares of common
      stock issuable upon exercise of the warrants. There were no other changes to
      either agreement. Both transactions closed and the warrants were issued on
      April
      27, 2006.





AMEX
      requires that shareholder approval be obtained by the Company for the sale
      of
      common stock in a transaction if the price of the shares to be sold is less
      than
      the greater of book or market value, and the number of shares is equal
      twenty-percent (20%) or more of the presently outstanding common stock. In
      order
      to comply with this requirement, the Company was required to obtain shareholder
      approval for the $4.0 and the $2.5 million Private Placements. Shareholder
      approval was obtained at the Company's annual shareholder meeting on July 6,
      2006.




14




**$1.0
      Million Private Placement**




On
      November 9, 2006, the Company issued 1,371,742 shares of the Company's common
      stock at a purchase price of $0.729 per share in a private placement for total
      proceeds of $1,000,000.





As
      part
      of the sale, the Company issued warrants to purchase 685,871 shares of common
      stock at an exercise price of $0.972 per share during the period of six months
      to sixty-six months subsequent to issuance. The warrants expire
      sixty-six months after the date of issuance. The investor's obligation to
      purchase the shares is subject to the Company satisfying certain additional
      conditions.





The
      common stock and the warrants were issued to the accredited investor in a
      transaction that is exempt from registration pursuant to Section 4(2) of
      the Securities Act, and/or Regulation D promulgated under the Securities
      Act.





The
      transaction closed and the funds were received on November 22,
      2006.





**Warrants**




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 to 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.





Item 6.
      Management’s Discussion and Analysis or Plan Of Operation





**Business
      Plan:**





The
      Company is classified as a development stage company as shown on our
      consolidated financial statements for the year ended December 31, 2006. In
      2006, we have not experienced sales of our O2D05 additive and O2DieselTM in
      sufficient volumes to cause our status as a development stage company to
      terminate. We anticipate that a change in our status as a development stage
      company will not occur until 2008 at the earliest. During 2007, we intend to
      devote our efforts to generating sales to our targeted customers in the U.S.,
      Asia, and Brazil; expanding sales and sponsorship revenues under our CityHomeTM
initiative; and continuing to improve our logistics network for the delivery
      of
      our products. In addition, we plan to continue a series of product tests and
      demonstrations that relate directly to our sales efforts, including having
      O2DieselTM designated as a Diesel Emissions Control Strategy fuel in California,
      attaining an ASTM specification for our additives and O2DieselTM; obtaining EPA
      verification and registration for O2DieselTM and several additional additives;
      obtaining approval for a Department of Defense procurement specification for
      a
      blended fuel containing O2DieselTM and biodiesel and expanding our test and
      demonstration efforts in Europe.





United
      States and Canada:




Our
      focus
      for the U.S. and Canada continues to be to target key geographical areas and
      specific diesel markets based upon:





·
            
            High-population
                centers under strict air quality regulations;·
            
            Municipal
                transit and school bus fleets with an emphasis on public policy and
                a
                positive environmental image;·
            
            Large
                concentrations of urban-based, centrally fueled fleets of trucks
                and
                buses;·
            
            Off-road
                diesel powered equipment;·
            
            Diesel
                equipment used by port facilities and large-scale mining
                operations;·
            
            Military
                installations in non-combat
                vehicles.





15




In
      the
      U.S., O2Diesel’s sales and marketing efforts for fleet sales will be focused in
      the state of California and the Midwest. In Canada, we intend to concentrate
      our
      efforts on the country’s large population centers in the Eastern and Western
      provinces, but until we have commercialized our technology in the US, no
      significant resources will be devoted to Canada.





We
      have
      an internal sales force to advance our sales efforts. During 2004, our sales
      force identified potential customers that fit the profile to use O2DieselTM.
      These were mainly centrally fueled fleets that were served by jobbers. In
      selling to these customers, we faced several challenges. Almost all of these
      challenges centered on the logistics for delivering O2DieselTM to the customer.
      O2Diesel has devised parallel strategies to meet our sales goals, and we are
      continuing to perfect these strategies.





Under
      the
      first element of our strategy, we have signed distribution agreements with
      12
      jobbers, who in turn have centrally fueled fleets as their customers. We plan
      to
      sell additive to the jobbers and assist them in purchasing ethanol by either
      locating ethanol suppliers or purchasing and reselling ethanol to them. However,
      we will only purchase ethanol as an accommodation to a jobber, because we do
      not
      wish to tie-up our limited working capital to finance the purchase of ethanol.
      The jobbers will blend our additive and ethanol with diesel fuel and then sell
      O2DieselTM to their customers. O2Diesel’s sales force and technical staff will
      work jointly with each jobber and it’s customers to assist in the transition
      from the use of regular diesel fuel to O2DieselTM. A key part of working with
      each customer is to provide safety and training materials covering the use
      of
      our fuel. In addition, O2Diesel’s technical staff plans to work with each
      customer in the process of purchasing and installing flame arrestors and other
      devices for customer vehicles and storage facilities. In most cases, we will
      be
      responsible for sourcing and installing these devices while, in other cases,
      our
      technical staff will only have an oversight role. Finally, our technical staff
      will work with the customer to insure that its storage facilities are clean
      and
      are compatible for storing and dispensing O2DieselTM.





During
      2004, we developed a sales and marketing concept styled as CityHomeTM, which we
      have continued to use as an important component of our test/demonstration
      strategy. This program stresses the environmental benefits of our fuel and
      is
      designed to improve the air quality in urban locations. In short, CityHomeTM
provides a means for municipal transit agencies to convert their fleets to
      O2DieselTM without having to pay the higher costs of our fuel. In 2006, we had
      four municipal fleets in smaller cities in the Midwest use O2DieselTM in
      CityHomeTM installations.





Through
      an innovative cost sharing concept with companies that wish to be good corporate
      citizens (sponsors), we have designed a program which permits the municipalities
      to purchase our fuel at costs which are the same as what they pay for regular
      diesel fuel. Corporate sponsors, generally with a national or international
      presence, will pay sponsorship fees to O2Diesel to take part in a clean air
      program for one or more of the communities participating in a CityHomeTM program.
      In return for sponsorship payments, each sponsor will be given access to
      currently unused advertising space on buses and other advertising assets owned
      by the municipality. Sponsorship fees will become additional revenue for us
      and
      will be recognized as such when the related advertising is displayed and all
      other criteria for revenue recognition have been met. Costs that are intended
      to
      be supported by the sponsorship fees are recorded separately in the related
      expense line in our statement of operations. With regard to the advertising
      space, since the CityHomeTM program is still limited in the number of
      installations and since we have been unable to assess the fair market value
      of
      the advertising space received, we assign no value to the space at the time of
      the receipt. We are recognizing the value associated with the advertising space
      when we enter into a contractual arrangement with a third party. The Company
      will consider assigning a fair value to the advertising space received at the
      time of the initial sale when such fair value is more readily determinable,
      based upon a history of cash transactions.





To
      date,
      we have used this initiative as an important component of our test/demonstration
      strategy and have been successful in attracting fuel distributors to work with
      us in getting this initiative started. However, while we have received
      sponsorship funding for our current CityHomeTM programs, the current fleet
      demonstrations being executed under this program have continued to require
      significant financial support from the Company. As a result, we have decided
      to
      limit new CityHomeTM programs to instances where we are assured of a level of
      sponsorship funding needed to cover all expenses of the demonstration. In
      addition, our participation in one of our CityHome fleets was reduced to a
      small
      number of vehicles and in another has been temporarily suspended due to issues
      relating to continued water contamination of the fuel supplied to these fleets.
      During 2006, the Company announced additional CityHomeTM initiatives in the
      Midwest with a company that operates both school bus and tour bus fleets and
      a
      company with a small school bus fleet in Chicago. These programs are the
      beginning of what is intended to be a larger program to fuel several school
      bus
      fleets in the Midwest, subject to adequate sponsorship support.





As
      another part of our sales strategy, O2Diesel’s sales force plans to market and
      sell O2DieselTM directly to large centrally fueled fleets, government
      municipalities and others that operate centrally fueled fleets of diesel powered
      equipment. These target customers may initially include truck, bus and school
      bus fleets, construction and mining companies as well as port facilities, and,
      later on, railroads, agricultural users, and the military. In this regard,
      the
      Company experienced continued commercial success in 2006 with its activities
      at
      the Port of Long Beach and is currently pursuing additional opportunities in
      this market segment. The Company also announced that the U.S. Air Force had
      approved the expansion of its successful test demonstration with a USAF base
      in
      Nevada, both in the number of vehicles to be used and the length of time the
      demonstration will now run. The Company concluded successful demonstrations
      at a
      municipal waste fleet in California and at a large coal mining operation in
      Wyoming.




16




To
      obtain
      potential customers or test demonstrations, we often have been responsible
      initially for all logistics required to deliver O2DieselTM to the customer. To
      achieve this end, we will continue to work with fuel distributors that have
      the
      ability to blend diesel fuel, ethanol and additives for delivery to a customer’s
      central fueling location. We will supply our additive and may purchase the
      ethanol for delivery to the fuel supplier, although our clear preference is
      to
      not finance the purchase of ethanol for our customers. In the process of
      transitioning a customer’s fleet to O2DieselTM, we need to put in place the
      logistical support to insure that fuel is delivered on a timely basis. In this
      regard, O2Diesel is seeking to create a network of ethanol suppliers and fuel
      transportation providers. With these large fleet customers, our technical staff
      will work closely with each in all facets necessary to prepare the vehicles
      or
      other equipment to use O2DieselTM. This will include a review of the customer’s
      fueling facilities for cleanliness and compatibility to O2DieselTM, arranging for
      the cleaning of tanks and filtering systems as necessary, as well as either
      purchasing and installing flame arrestors and other devices or assisting the
      customer to do so.





We
      have
      also expanded our efforts to establish and improve the logistics network
      required for the delivery of O2DieselTM to fleet and CityHomeTM customers. These
      efforts have centered on developing strategic relationships with ethanol
      producers and distributors in order to improve both quality consistency and
      price stability. At the end of 2006, the Company had succeeded in negotiating
      supply agreements with two ethanol industry groups to obtain a supply of limited
      amounts of ethanol at preferential pricing for our Midwestern
      customers.





In
      addition, the Company has entered into an agreement to acquire an 80% ownership
      share in ProEco Energy Company (“ProEco”), which is planning to build a 100
      million gallon ethanol plant in South Dakota. Once this acquisition has closed
      and the plant is operational, it is expected that this facility will provide
      a
      reliable source of high quality, competitively priced ethanol for the Company
      to
      use in developing its commercial markets.





Europe




In
      Europe, 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 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 has identified two
      municipal transit fleets, a waste truck fleet and a port facility that were
      interested in evaluating O2DieselTM fuel during test demonstrations. We expect
      these or other potential customers to develop into demonstration programs in
      2007.





Asia




In
      Asia,
      we negotiated an exclusive distribution agreement in 2006 with an Asian supplier
      of alternative fuels and its wholly owned subsidiary to provide funding and
      commercial support to develop a market in certain countries in South Asia and
      Asia Pacific for the Company’s products. Recently, this company announced that
      it had concluded a successful trial demonstration of the fuel and have commenced
      supplying the first 2,500 buses of a large municipal fleet in Karnataka, India.





Brazil




In
      Brazil, O2Diesel is targeting customers on a very focused basis. In general,
      these will be miller fleets (sugar and ethanol producers), municipal bus and
      other fleets, and to a lesser extent centrally fueled truck fleets. Up until
      2006, we had established a small sales force and technical staff in Brazil.
      The
      roll out of our product has been much slower than planned. Obtaining government
      approvals and gaining market awareness has taken longer than we anticipated.
      In
      addition, the cost of ethanol in Brazil remains relatively high, making it
      difficult to produce our blended fuel at a cost competitive level. In response
      to these matters, we have made a decision to follow a less aggressive marketing
      strategy for Brazil. We have taken steps to continue to reduce our overhead
      and
      scaled back our marketing plans and staff until we have a solid base of
      customers in Brazil. During 2006, we successfully completed our demonstrations
      in three test fleets, continued our support of a fourth test fleet and entered
      into negotiations with a municipal bus fleet in Curitiba.





Brazil's
      fuel distribution system is more concentrated than in the U.S. As a consequence,
      O2Diesel must join with one or more large fuel distributors that can blend
      and
      deliver O2DieselTM to customers in Brazil. In January 2005, we signed a
      Memorandum of Understanding with a company reported to be the sixth largest
      fuel
      distributor in Brazil. This company was to serve as our exclusive distributor
      for O2DieselTM in the South and Southeastern regions of Brazil. This Memorandum
      of Understanding is no longer in place, since O2Diesel has decided to cooperate
      on a non-exclusive basis with Brazil's largest fuel distributor, BR, the
      distribution arm of the state-owned mineral oil company Petrobrás. BR/Petrobrás
      is to supply readily blended O2Diesel fuel to the municipality of Rio de
      Janeiro. 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.




17





At
      the
      beginning of 2007, the Company has succeeded in verifying its technology in
      several demonstration fleets and has seen a reduction in the market price of
      ethanol. 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 in order to negotiate such supply contracts.




**Cash
      Requirements and Risk Factors:**





Based
      on
      current projected levels of operations and expenditures, we will need to raise
      additional funds over the next twelve months. At December 31, 2006, we do not
      have any bank trade facilities. However, if the Company achieves significant
      sales, we plan to apply for trading lines with banks in the U.S., Europe or
      Brazil as a means to finance our working capital needs.





Significant
      technical and logistical issues have affected our ability to generate sales
      in
      2005 and 2006. While we have made substantial progress in addressing these
      challenges over the course of the year, they have impeded our efforts to
      commercialize O2DieselTM fuel. In general, these challenges fall into the
      following categories: (1) logistics of delivering and dispensing O2DieselTM,
      (2) sourcing and installation of flame arrestors and other devices in
      vehicles and storage facilities, (3) negotiating reliable,
      price-competitive supplies of fuel grade ethanol, (4) ensuring that fuel
      tanks are appropriately cleaned, and (5) obtaining regulatory approval and
      an
      industry accepted specification for our “e-diesel” (ethanol-diesel) fuel.
      O2Diesel has devised several strategies to meet these challenges and has
      undertaken a variety of activities to overcome them and to position O2DieselTM as
      a premium clean-burning fuel.





Under
      the
      first element of our strategy, we have signed distribution agreements with
      twelve jobbers, who in turn have centrally fueled fleets as their customers.
      We
      sell additive to these jobbers and assist them in purchasing ethanol by either
      locating ethanol suppliers or purchasing and reselling ethanol to them. However,
      we will only purchase ethanol as an accommodation to a jobber, because we do
      not
      wish to tie-up our limited working capital to finance the purchases of ethanol.
      The jobbers blend our additive and ethanol with diesel fuel and then sell
      O2DieselTM to their customers. O2Diesel's sales force and technical staff work
      jointly with each jobber and the jobber's customers to assist in the transition
      from the use of regular diesel fuel to O2DieselTM. A key part of working with
      each jobber and its customers is to provide safety and training materials
      covering the use of the fuel. In addition, O2Diesel's technical staff works
      closely with each customer in the process of purchasing and installing flame
      arrestors and other devices for customer vehicles and storage facilities. In
      most cases, we are responsible for sourcing and installing these devices while,
      in other cases, our technical staff will only have an oversight role. Finally,
      our technical staff will work with the customer to insure that its storage
      facilities are clean and are compatible for storing and dispensing
      O2DieselTM.





In
      addition, our sales force plans to market and sell O2DieselTM directly to
      companies, governmental port facilities and others that operate large centrally
      fueled fleets. These customers may include large truck and bus fleets,
      construction fleets, municipalities, and mining companies as well as port cargo
      handling facilities and agricultural users. To date, these customers have only
      included centrally fueled truck fleets and cargo handling facilities at a major
      port. In these transactions, the Company will maintain a similar working
      relationship with the customer's blending facilities and staff as it does with
      third party jobbers.





Secondly,
      as part of the process by which O2DieselTM was approved for sale in California,
      the California Air Resources Board set a number of conditions that we must
      adhere to on an ongoing basis. One of the conditions is that all storage tanks
      in which O2DieselTM is stored and all vehicles that use the fuel must be fitted
      with devices known as flame arrestors. Flame arrestors are safety devices which
      are intended to prevent a fire in case a spark or other type of ignition might
      inadvertently enter the fill inlet of a fuel tank. Imposing this requirement
      proved to be a serious issue in 2004 and early 2005, and negatively impacted
      our
      ability to efficiently commercialize our technology in the U.S. Even though
      flame arrestor technology has been used for many years in other applications,
      flame arrestors in the required sizes and designs were not yet available as
      an
      "off the shelf item" for use with O2DieselTM during this time. At the end of
      2006, the flame arrestor challenge had been largely resolved for the vehicles
      within O2Diesel's target markets.





Third,
      we
      have confirmed that it is important to carefully select ethanol suppliers
      because there is a wide range of fuel grade ethanol in the marketplace. It
      is
      critical that the ethanol component of O2DieselTM be of a consistently high
      quality and that it meet certain other specifications. Selection of ethanol
      suppliers and creating a relationship with those that can provide the quality
      of
      product we require is a significant need, and is a task that we will devote
      more
      time to during 2007. We are currently working closely with the industry to
      identify ethanol suppliers who meet our criteria. In the third quarter of 2006,
      we had succeeded in obtaining contracts with two ethanol industry groups to
      provide a supply of limited amounts of ethanol at preferential pricing for
      our
      Midwestern customers. In addition, the Company recently announced its intention
      to purchase a controlling interest in ProEco, an engineering company that is
      intending to build a new ethanol manufacturing facility in South Dakota. Once
      this transaction has closed and the plant is operational, it is O2Diesel’s
      intention to use the ethanol produced at this facility for its continued
      commercialization and demonstration efforts and to sell any additional output
      on
      the open market.





18




In
      order
      to ensure fuel quality, we have developed a quality control function that
      constantly tests the ethanol used by all customers. In addition, we have learned
      that it is necessary to test the quality of diesel blended with our additive
      and
      ethanol. Establishing our own laboratory facility has been a significant help
      to
      us in developing quality control standards, and for carrying out the tests
      that
      are necessary in preparing a fleet for conversion to use O2DieselTM.
      Additionally, the Company has installed several testing devices in the field
      so
      that samples can be evaluated more efficiently than with a centralized
      laboratory alone. None of these tests are time consuming or technically
      difficult, but they are critical to ensuring that our product functions as
      intended. As we gain more experience, it may not be necessary to conduct the
      level and frequency of tests that we expect to do over this coming
      year.





The
      Company has seen that even with a reliable supplier, the price of ethanol can
      be
      volatile as a result of a number of factors, such as the overall supply and
      demand, the level of government support, and the availability and price of
      competing products. For example, many petroleum refiners have recently replaced
      methyl tertiary butyl ether (MTBE) in gasoline with ethanol during the second
      quarter of 2006. The replacement of this ingredient in gasoline has caused
      the
      demand for ethanol to increase dramatically, with a corresponding increase
      in
      its price. A benefit of this phenomenon has been to increase the availability
      of
      ethanol at petroleum terminals when compared to the recent past. However, the
      rise in the cost of ethanol has made the price of O2DieselTM fuel increase in
      relation to conventional diesel fuel during the second half of 2006. In 2007,
      it
      is the Company's strategy to help control the costs of ethanol and reduce
      short-term exposure to price fluctuations by continuing our contracts with
      the
      ethanol industry groups for limited amounts of ethanol at preferred prices
      and
      purchasing ethanol from the proposed plant to be built by ProEco.




Another
      concern we have relates to the logistics and storage of O2DieselTM for fleets and
      other diesel equipment that may use the fuel. In particular, it is very
      important that storage tanks be cleaned prior to the introduction of O2DieselTM
into the customer's refueling station. We have made important strides in working
      with customers to insure that their storage facilities are compatible with
      O2DieselTM and have now included this step as a critical component of our
      implementation planning process.





The
      Company has taken several steps in 2005 and 2006 to overcome these problems
      and
      to support the introduction of O2DieselTM fuel to new customer opportunities.
      First, we assembled our knowledge and documentation regarding the design
      requirements of flame arrestors in the market areas we served and developed
      a
      catalogue of flame arrestors and parts that can be used for a wide variety
      of
      engine/vehicle types and customer applications. Second, we developed a checklist
      of procedures to be used by our technicians (in conjunction with our customer)
      that enabled our technicians to prepare a comprehensive fleet profile of
      hardware requirements, tank cleaning procedures and the time required to perform
      the work necessary to bring a fleet on-line. Third, we have identified several
      equipment vendors who we now work with so that needed equipment can be delivered
      to customer locations quickly and at competitive prices. Fourth, we have
      developed a training program that will enable our technicians to teach our
      customer's fleet maintenance staff about handling and storing O2DieselTM fuel,
      fleet modification and maintenance issues that can be expected. Finally, we
      have
      developed a modest parts inventory at our laboratory facility so that in the
      event of an emergency, required parts can be supplied to our
      customers.





Our
      present planning methodology is based on a 40-day implementation time frame
      that
      requires the project to be a joint effort utilizing the customer's employees
      and
      identifies the timing and costs that the customer can expect. During 2005,
      we
      continued the research and development efforts begun in 2004 to design and
      to
      identify flame arrestors, adaptors and other equipment for vehicles that use
      O2DieselTM. Some of these devices have undergone and passed tests to insure that
      they are capable of complying with all required specifications. In 2005, other
      flame arrestors were developed and subjected to the required tests. In addition,
      we have learned that certain engines require the fitting of a primer pump to
      insure that the vehicle starts and runs properly in hot weather. These devices
      are simple and readily available and the costs are known, but the necessity
      of
      adding these devices to certain vehicles could increase our costs and may
      increase the time required to transition a fleet from using regular diesel
      fuel
      to the use of O2DieselTM. Lastly, in some buses, we have had to install safety
      fueling devices in the fuel inlet that serve the function of flame arrestors,
      but are generally more expensive. These particular devices are readily available
      in the market. To support our implementation efforts, we commissioned a third
      party engineering consulting firm to review our written safety training
      procedures as well as to conduct on-site reviews of four of our customer
      locations in order to evaluate the adequacy of the training and the quality
      of
      safety procedure implementation. The ensuing report from the consultant
      indicated that our safety program requirements were well conceived and were
      being followed quite closely at all locations. Additional safety procedures
      to
      enhance this program are currently being evaluated.





All
      of
      these issues have led to a greater lead time than expected to convert a fleet
      from using regular diesel to O2DieselTM. In fact, we have seen that the time it
      takes to do the conversion work can be the most important factor in bringing
      on
      more customers to use our fuel. As a means of mitigating the time required
      for
      converting a fleet, we have sought to have our customers complete much of this
      work under our direction. However, this policy is dependent upon obtaining
      an
      agreement from the customer to do the work. The actual time required to convert
      a fleet to use O2DieselTM may be further limited by the availability of the
      customers' vehicles to be in one place long enough to effect the required
      changes. In some cases for safety, insurance or union reasons, customers will
      require that they complete all of the work necessary for their vehicles and
      diesel powered equipment to use O2DieselTM, as well as arranging to insure that
      their storage and dispensing facilities are compatible with the use of the
      fuel.
      The Company anticipates that the work completed in 2005 and 2006 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.




19




The
      technical challenges over this past year have presented significant hurdles
      to
      commercializing our technology. In most cases, we have overcome these obstacles
      by the application of technical resources, payments to support our customers
      and
      a high level of customer service. All of this has been time-consuming and has
      slowed our ability to bring our product to market. But it has also created
      a
      base of knowledge which is helpful as we continue our efforts to commercialize
      our technology in the U.S., Europe and other markets. We have been encouraged
      by
      the fact that among our customers, we have a municipal bus fleet and a port
      facility that have been successfully utilizing the fuel for approximately two
      years. The municipal customer received an award for innovation from its public
      transit association for the success it achieved in reducing emissions through
      the use of O2DieselTM fuel. Even though we have gained a significant amount of
      technical knowledge, we will continue to refine our efforts in this area in
      order to improve our ability to bring on greater numbers of customers and to
      better predict the cost and timing of the work required to have fleets conform
      to the requirements of using our product.




As
      previously described in the Government Approvals section, the Company is
      continuing its efforts to certify its additives and O2DieselTM
      under the requirements of the Environmental Protection Agency (EPA), the
      California Air Resources Board (CARB) and the American Society for Testing
      and
      Materials (ASTM). Completion of these certification requirements will support
      our efforts to develop an alternative fuel specification for the Department
      of
      Defense. Obtaining each of these approvals is critical to successful
      commercialization of the Company’s products.





Given
      our
      projected level of expenses and the cash on hand as shown on our consolidated
      audited balance sheet at December 31, 2006, it is clear that we lack
      adequate cash to conduct our business according to our business plan. Throughout
      2006, the Company received nearly $9.0 million from various warrant offerings
      and private placements. As described in footnote 11 (Subsequent Events), on
      February 22, 2007, the Company announced it had entered into a private
      placement agreement to raise up to $10 million, subject to certain conditions.
      Even with the capital raised in 2006 and the $10 million private placement,
      we
      believe it may be necessary to raise additional funds in 2007 to allow us to
      execute our business plan and to be in compliance with the AMEX’s listing
      standards.





There
      can
      be no assurance that we will be successful in our efforts to raise additional
      funds. Nor can there be any assurance that the Company will generate sales
      and
      collect cash to offset our operating expenses. As shown in the consolidated
      audited statements of operations contained in this report, we have generated
      only $250,934 in total revenues for calendar year 2006. As of the date of this
      report, we have only minimal orders on hand for either our additives or
      O2DieselTM. Lastly, there can be no assurance that actual events will not differ
      from those anticipated, or that general economic conditions may not vary
      significantly in ways that could negatively impact our operations and cash
      position.





**Research
      & Development:**




The
      Company has 109 patent applications covering eight different fuel and additive
      inventions relating to proprietary products registered with the international
      WIPO (PCT) Registration System. Four inventions currently have patents granted
      in a total of 32 countries in Europe, North America, Central America and Asia.
      An additional twelve applications relating to these inventions are pending.
      The
      other four inventions are either undergoing examination at the national level
      or
      are about to do so in various countries. If successful, these other four
      inventions could add up to 65 additional granted patents over the next two
      years. During this period, O2Diesel’s intellectual property rights over its
      additive products are protected through its registration with the WIPO (PCT)
      Registration System and its pending national patent applications.





As
      part
      of our cooperation agreement with Cognis, we, along with Cognis, are the joint
      owners of all patents covering both the use and composition of O2D05. All legal
      costs associated with preparing, filing and administering the jointly owned
      patents are shared equally by the Company and Cognis. We also have a number
      of
      patents that have been issued that relate to the predecessor technology of
      O2D05. As a strategic measure, we continue to fund all costs necessary to
      maintain some of these patents. O2Diesel is the sole owner of these latter
      patents, which in general cover the use and composition of its prior generation
      technology.





We
      have
      filed trademark registration applications in the U.S. and the European Union
      for
      a mark which includes the words and numbers O2DieselTM as well as a figurative
      logo of the words.





As
      mentioned earlier, we developed a new marketing initiative in 2004 which is
      styled as CityHomeTM. On November 11, 2004, we filed applications for the
      trademark “CityHome” (and design) in eight classes of goods and services. Final
      approval of the trademark was received in April, 2006. Applications were also
      filed for the trademarks “TODAY’S CLEAN AIR SOLUTION TOMORROW’S BRIGHTER FUTURE”
and “CITYHO2ME”, each covering one class of goods and services. Final approvals
      of the trademarks were received in May 2006.





During
      2006, we 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. More specifically, in 2006, we incurred expenses of
      approximately $1.9 million 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
      start of 2007, we have government test programs in progress with total remaining
      costs to complete of approximately $1.2 million. Under these programs a
      wide array of engine tests and product demonstrations are to be conducted to
      further prove the emissions benefits of O2DieselTM and to show that the fuel
      performs well in specific applications.




20




Included
      in the foregoing programs is a product demonstration in Nevada to test O2DieselTM
in non-tactical military equipment. Other programs underway include completing
      the protocols to allow O2DieselTM to be classified as a Diesel Emissions Control
      Strategy fuel by the California Air Resources Board. O2DieselTM is conducting
      demonstrations with a number of school bus and transit agencies testing
      O2DieselTM as well as O2DieselTM blended with B20 in various weather conditions,
      engine types, and uses. Still other tests include using O2DieselTM in large
      mining equipment as well as seeking to obtain a military procurement
      specification for the fuel. In January 2006, we initiated a project to develop
      a
      fuel that would meet EPA’s alternative fuel requirements for the military. Based
      on the government funding in place, we believe that approximately 80% of the
      costs to conduct these tests may be funded by appropriations from the U.S.
      Departments of Energy and Defense.





We
      will
      also continue to devote time and to invest in the design and development of
      flame arrestor technology. We have found that this is more labor intensive
      and
      time consuming rather than requiring large outlays of capital. Most of the
      design work has been performed by our own personnel and consultants with the
      actual fabrication work contracted out to specialized manufacturers. We expect
      this work to continue in 2007.





In
      2006,
      we spent about $3,300 USD in Brazil for research and development projects and
      to
      obtain approvals for O2DieselTM from the agencies in Brazil 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
      O2DieselTM may be sold in Brazil. In 2004, we submitted applications to both
      agencies and received limited, but favorable approvals from each. ANP has
      classified O2DieselTM as an alternative diesel fuel. In addition, IBAMA, approved
      O2DieselTM for off road (e.g. in mining) and railroad applications. Also, in
      response to requests that we submitted to ANP, it granted approval for O2DieselTM
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 2007,
      we
      do not anticipate spending any funds on various product and vehicle tests in
      Brazil.





**Employees:**




At
      present, O2Diesel has seventeen full-time employees, sixteen of which are in
      the
      U.S. and one is in Europe. We have one part-time employee. During this past
      year, we have relied on consultants to assist in commercializing our technology
      and to help us in key technical areas. We expect to continue this practice
      in
      2007. At present, we employ eight consultants in the U.S.; four in marketing
      and
      business development; one field technician, one laboratory technician, one
      chemist; and one in regulatory affairs. The Company has entered into separate
      consulting contracts with two shareholders of its Brazilian subsidiary for
      the
      purpose of providing office rent and administrative services and in lieu of
      employment contracts with these two individuals. In Europe, we employ two
      consultants, one for general management and business development and one for
      regulatory affairs.





We
      will
      add new personnel in 2007 based on the pace of our commercialization. Under
      our
      business plan, we do not see the need to add employees in the U.S. or Brazil,
      but we do plan to add technical positions for our European market testing and
      development in 2007. We anticipate continuing to employ twelve consultants
      serving in most of the same capacities in 2007 as in 2006.




21


Item
      7.
      Financial Statements




The
      Company's Consolidated Financial Statements are
      filed with and begin on Page F-1 of this Report.




Item 8.
      Changes in and Disagreements with Accountants on Accounting and Financial
      Disclosures





There
      were no disagreements with accountants on accounting and financial disclosures
      during the fiscal year 2006 that were not previously disclosed.





Item 8A.
      Controls and Procedures





Disclosure
      adjustment to Internal Controls :




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
      annual report (the “Evaluation Date”). Based on such evaluation, such officers
      have concluded that, as of the Evaluation Date, O2Diesel’s disclosure controls
      and procedures are effective.





CHANGES
      IN INTERNAL CONTROLS OVER FINANCIAL REPORTING. During the most recent fiscal
      year, 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.





Item 8B.
      Other Information




There
      were no disclosures of any information required to be filed on Form 8-K during
      the fourth quarter of 2006 that were not filed.


On
        March
        26, 2007, the Company entered into an Amendment No. 1 to Employment Agreement
        (the “Amendment”) with David Shipman, its Chief Financial Officer (the
“Executive”). The Amendment increased Mr. Shipman’s salary by 18.3%. A copy of
        the Amendment is filed hereto as Exhibit 10.31 and is incorporated herein
        by
        reference. ****





22




PART
      III





**Item 9.
      Directors, Executive Officers, Promoters, Control Persons and Corporate
      Governance; Compliance With Section 16(a) of the Exchange
      Act**




The
      following sets forth the names and ages, as of March 27, 2007, of the
      nominees for election to the Board of Directors, as well as the directors whose
      terms will continue, their respective positions and offices with the Company,
      the period during which each has served as a director of the Company and their
      principal occupations or employment during the past five years.




**Name**
            
            **Age**
            
            **Position**Hendrik
                Rethwilm
            
            42
            
            DirectorKarim
                Jobanputra
            
            43
            
            DirectorDavid
                L. Koontz
            
            64
            
            DirectorAlan
                R. Rae
            
            48
            
            Chief
                Executive Officer and DirectorE.
                Holt Williams
            
            64
            
            DirectorArthur
                E. Meyer
            
            79
            
            Chairman,
                Board of DirectorsJeffrey
                L. Cornish
            
            55
            
            DirectorGerson
                Santos-Leon
            
            47
            
            DirectorRichard
                Roger
            
            47
            
            President
                and Chief Operating OfficerDavid
                Shipman
            
            59
            
            Chief
                Financial Officer





***Hendrik
      Rethwilm*** has been
      a Director since July 15, 2003 and serves on the Governance and
      Compensation Committees. From 1993-


1999,
      he
      worked with PricewaterhouseCoopers in its corporate finance department focusing
      on financial and organizational restructuring of medium-to-large sized
      companies. Subsequently, from 2000-2001, Mr. Rethwilm worked with a
      subsidiary of Ericsson, the Swedish mobile phone producer, as a financial
      executive advising on mobile eCommerce. During his tenure with Ericsson,
      Mr. Rethwilm also developed a venture capital arm within Ericsson
      Consulting to invest in companies developing applications for the mobile
      eCommerce sector. Currently, Mr. Rethwilm is self-employed and provides
      consulting services to various companies in the areas of corporate finance
      and
      business development. He previously served on the board of directors of
      Rapidtron, Inc., a company that trades on the OTCBB under the symbol “RPDT”, but
      resigned effective December 31, 2003.




***Karim
      Jobanputra*** has been
      a Director since July 15, 2003. Mr. Jobanputra is an entrepreneur and
      owns companies that do business mostly in the Middle East and Europe.
      Mr. Jobanputra has experience in the areas of corporate finance and
      international, business development, and also works as a self-employed
      consultant based in the United Kingdom. For the past five years he has
      provided consulting services to companies in the areas of corporate finance
      and
      business development in the Asian and Middle East markets, including Indonesia,
      Qatar, Saudi Arabia, India and China.




***David
      L. Koontz*** has been
      Chief Financial Officer for Waco Logistics Group, Inc. since August, 2005.
      From
      July 15, 2003 to August 6, 2005 he was the Chief Financial Officer and
      Secretary of the Company and has been a Director of the Company since
      July 15, 2003. He joined the AAE Group in September 2002, serving
      first as the Chief Financial Officer and Secretary of O2Diesel, Inc. Prior
      to
      joining the Company, Mr. Koontz had worked primarily as an independent
      business consultant, mostly with businesses located in Asia, for the period
      January 2000 to September 2002. During 1999, Mr. Koontz acted as
      a consultant and chief financial officer for an apparel company in Boulder,
      Colorado. Mr. Koontz was a partner with Arthur Andersen & Co. until
      1988 and holds a CPA certificate.




***Alan
      R. Rae*** has been
      the Chief Executive Officer and a Director of the Company since July 15,
      2003, the Secretary since August 6, 2005 and President between
      July 15, 2003 to July 28, 2005. Mr. Rae joined the AAE
      Technologies group of companies in 1997, and has served as a Director and an
      executive of several companies within the group. In August 1999, he became
      a Director and President of AAE Technologies, Inc. (now O2Diesel Inc.), and
      in
      October 2000 became a Director and Chief Operating Officer of AAE
      Technologies International PLC and continues to hold these positions in both
      companies. Mr. Rae was a Director and the Chief Executive Officer of AAE
      Holdings plc (UK) from October 1998 until September 2001. He was
      the Chief Executive Officer and a Director of AAE Technologies Ltd. from
      October 1997 until September 2001.




***E. Holt
      Williams*** has been
      a Director since May 31, 2005 and is the Chairman of the Audit Committee
      and is a member of the Governance Committee. He has served as the Chairman,
      CEO
      and also as the CFO for Coastal Equipment Inc. for over 27 years. He headed
      both the domestic and foreign operations of the company, which were centered
      in
      the Gulf States of the US and in Asia. Prior to entering the private sector,
      Mr. Williams practiced as a certified public accountant with an
      international accounting firm. He has also been active in buying and selling
      real estate in Houston, Texas. Mr. Williams is a member of and has served
      in various capacities on a number of professional, charitable and civic groups
      such as U.S. Chamber of Commerce; Singapore American Chamber of Commerce;
      Houston Foreign Affairs Group; Georgetown University McDonough School of
      Business and various other civic, school and church related organizations.
      He
      holds a B.S. degree in Accounting and an M.B.A. In addition, he maintains
      professional certification as a CPA.




***Arthur
      E. Meyer*** has been
      Chairman of the Board since May 31, 2005 and serves on the Compensation,
      Governance and Audit Committees. He has served as the Executive Vice President
      and Vice Chairman of Board of Mohawk Oil Company Canada Limited until its sale
      to Husky Oil Co. Ltd. Mr. Meyer has a long history of experience in crude
      oil refining, product development, distribution and marketing. He has a wide
      background in all facets of the petroleum industry in Canada, including building
      the first ethanol plant in Canada as well as managing the blending and marketing
      of Gasohol in Canada. Mr. Meyer has been member of the Board of several oil
      companies in Canada, and has served on the Boards of a number of universities
      and other organizations, including the University of Calgary, Northern Alberta
      Institute of Technology, Consulting Engineers of Canada, National Biotechnology
      Committee and the FBC Foundation of Calgary. Mr. Meyer holds a degree in
      Mechanical Engineering from the University of Saskatchewan.




23




***Jeffrey
      L. Cornish*** has been
      a Director since May 31, 2005 and serves on the Audit and Compensation
      Committees. He currently serves as President of Performance Transportation
      Services (PTS). Prior to his service with PTS, Mr. Cornish was the Senior
      Vice President-Finance, Chief Financial Officer and Chief Information Officer
      for Pilot Travel Centers LLC for many years. He has rich and varied experiences
      in executing joint ventures, developing large financing vehicles to support
      large-scale growth of petroleum retailing businesses and restaurant franchisee
      operations. Mr. Cornish has held several other senior financial management
      positions, including senior level director and consulting positions for Coopers
      & Lybrand and Price Waterhouse. He has served on several municipal and
      Chamber of Commerce boards and holds a BA degree in Accounting and an MBA in
      Finance. He holds professional certifications as a CPA and a CMA.




***Gerson
      Santos-Leon*** is
      serving as the R&D Corporate Director of the Abengoa Bioenergy Group. He is
      responsible for developing technologies for the conversion of renewable biomass
      resources to ethanol, related co-products and utilization technology. Prior
      to
      his service at Abengoa, Mr. Santos-Leon led the Biofuels Program at the U.S.
      Department of Energy Office. He has served on a number of management boards
      responsible for evaluating and developing energy programs and has over twenty
      years of experience in the energy sector developing nuclear and renewable
      technologies. Mr. Santos-Leon holds a Chemical Engineering degree.




***Richard
      Roger*** has been
      President and Chief Operating Officer of the Company since July 28, 2005
      and served as a Director of the Company from April, 2004 to July 28, 2005.
      Prior to joining the Company, Mr. Roger was the President and Chief
      Executive Officer at Performance Transportation Services (PTS). Prior to working
      at PTS, Mr. Roger was the President and Chief Executive Officer of U.S.
      Fleet Service. Prior to working at US Fleet, Mr. Roger spent 20 years
      in the trucking and logistics sector with Ryder Systems holding various
      operational and executive positions - the most recent being Senior Vice
      President of Operations.




***David
      H. Shipman*** has been
      the Chief Financial Officer of the Company since October 1, 2005. Prior to
      joining the Company, Mr. Shipman was the Vice President/Chief Operating
      Officer at Kurz-Hastings, Inc. (“Kurz”). Prior to his position as Chief
      Operating Officer at Kurz, he served as the company’s Chief Financial Officer
      and Controller for 18 years. Before his service with Kurz, he spent four
      years as a management consultant at Deloitte Haskins & Sells and three years
      as an officer in the United States Air Force. Mr. Shipman holds a
      professional certification as a CPA, and has an M.B.A., Finance from the Wharton
      School, a B.A. , English from Trinity College and a M.S. Communications from
      Boston University.





***Audit
      Committee***




On
      May 27, 2004, the Board established and approved an Audit Committee. The
      Audit Committee has three members, Mr. E. Holt Williams (Chairman),
      Mr. Jeffrey L. Cornish and Mr. Arthur E. Meyer. The Board has
      determined that two directors who serve as members of the Audit Committee,
      Mr.
      Williams and Mr. Cornish, are “financial experts” as defined in SEC
      rules.





***Code
      of Business Conduct and Ethics***




On
      June 29, 2004, the Board adopted a Code of Business Conduct and Ethics that
      applies to all of the Company’s employees. A copy of the Code of Business
      Conduct and Ethics is available on our website *http:/www.o2diesel.com.*  The
      Code
      of Conduct and Ethics addresses the professional, honest and candid conduct
      of
      each director, officer and employee; conflicts of interest, disclosure process,
      compliance with laws, rules and regulations, (including insider trading laws);
      corporate opportunities, confidentiality, fair dealing, protection and proper
      use of Company assets; and encourages the reporting of any illegal or unethical
      behavior. W e
      intend
      to post notice of any waiver from, or amendment to, any provision of our code
      of
      ethics on our web site. Upon written request to the Secretary at 100 Commerce
      Drive, Suite 301, Newark, Delaware 19713, the code is available in print to
      any shareholder.





***Section 16(a)
      Beneficial Ownership Reporting Compliance***




Section 16(a)
      of the Exchange Act requires the Company’s executive officers, directors and
      persons who beneficially own more than 10% of a registered class of the
      Company’s equity securities to file with the SEC initial reports of ownership
      and reports of changes in ownership of Common Stock and other equity securities
      of the Company. Such executive officers, directors, and greater than 10%
      beneficial owners are required by SEC regulation to furnish the Company with
      copies of all Section 16(a) reports filed by such reporting
      persons.




Based
      solely on our review of such forms furnished to the Company and written
      representations from certain reporting persons, except for two directors and
      one
      beneficial owner, we believe that all filing requirements applicable to our
      executive officers, directors and greater than 10% beneficial owners were
      complied with during fiscal 2006. Director Gerson Santos-Leon did not file
      a
      Form 3 within ten business days. One beneficial owner and Director, E. Holt
      Williams, did not file a Form 4 within two business days to report one
      transaction. These missed filings were inadvertent and the required filings
      have
      since been made.




24




**Item 10.
      Executive Compensation**





The
      following summary compensation table sets forth the aggregate compensation
      paid
      or accrued by the Company to the Named Executive Officers for the fiscal year
      ended December 31, 2006.


**SUMMARY
          COMPENSATION TABLE**
 NonqualifiedDeferredOption
                
                Non-Equity
                
                Compensation
                
                All
                    OtherName
                    &
                
                
                
                Salary
                
                Bonus
                
                Stock
                
                Awards
                
                Incentive
                    Plan
                
                Earnings
                
                CompensationPrincipal
                
                
                
                ($)
                
                ($)
                
                ($)
                
                ($)
                
                Compensation
                
                ($)
                
                ($)
                
                TotalPosition
                
                Year
                
                (1)
                
                (2)
                
                (3)
                
                (4)
                
                ($)
                
                (5)
                
                (6)
                
                ($)Alan
                    RaeChief
                    Executive Officer
                
                
                2006
                
                $
                254,000
                
                $
                0
                
                $
                0
                
                $
                13,610
                
                $
                0
                
                $
                0
                
                $
                30,531
                
                $
                298,141Richard
                    RogerPresident
                    & COO
                
                
                2006
                
                $
                250,000
                
                $
                0
                
                $
                0
                
                $
                108,890
                
                $
                0
                
                $
                0
                
                $
                15,012
                
                $
                373,902David
                    H. ShipmanChief
                    Financial Officer
                
                
                2006
                
                $
                177,500
                
                $
                0
                
                $
                0
                
                $
                46,550
                
                $
                0
                
                $
                0
                
                $
                17,967
                
                $
                242,017




(1)
              
              In
                  addition to his position as the Chief Executive Officer, Mr. Rae
                  serves on the Board of Directors, but does not receive any compensation
                  for service as a Director. On March 26, 2007, the Company increased
                  David
                  Shipman's salary to $210,000, effective as of January 1,
                  2007.(2)
              
              Pursuant
                  to the terms of his employment agreement, Mr. Roger received a
                  special
                  bonus of $75,000 in January 2007, which is not included in the
                  preceding
                  table.(3)
              
              On
                  November 16, 2006, the Board of Directors approved a grant of 500,000
                  shares of restricted stock to Mr. Roger, pursuant to the terms
                  of the
                  Company’s 2004 Stock Incentive Plan (the “Stock Incentive Plan”) and Mr.
                  Roger’s employment agreement. The terms of the award are that the
                  shares are 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. Each share amount is
                  contingent
                  on Mr. Roger remaining employed by the Company on the date of vesting.
                  Mr.
                  Roger received his first award of 166,667 shares in January 2007
                  valued at
                  $0.82 per share, which is not included in the preceding table.
                  In 2006,
                  there was no SFAS 123(R) expense for the grant of restricted stock.(4)
              
              These
                  amounts reflect the dollar amounts recognized for financial statement
                  reporting purposes for the fiscal year ended December 31, 2006,
                  in
                  accordance with SFAS 123(R) for awards pursuant to the Stock Incentive
                  Plan and thus may include amounts from awards granted in and prior
                  to
                  2006. Assumptions used in the calculation of these amounts are
                  included in
                  footnote 2 to the Company’s audited financial statements for the fiscal
                  year ended December 31, 2006.(5)
              
              The
                  Company maintains a voluntary 401(k) plan for its employees and
                  did not
                  make any contributions in 2006. The Company does not maintain any
                  other
                  qualified retirement plans or non-nonqualified deferred compensation
                  plans
                  for its employees or directors.(6)
              
              In
                  2006, the Company paid to each of Mr. Rae, Mr. Roger and Mr. Shipman
                  an
                  automobile allowance of $12,000. In addition, the Company paid
                  health
                  insurance premiums for Mr. Rae in the amount of $18,531; for Mr.
                  Roger in
                  the amount of $3,012; and for Mr. Shipman in the amount of $5,967.




25




**GRANTS
      OF PLAN BASED AWARDS**


Estimated Future Payouts Under
                Non-Equity
                  Incentive Plan Awards
              
              Estimated
                  Payouts Under
                Equity
                  Incentive Plan AwardsName
              
              Grant
                  Date
              
              Threshold
                ($)
              
              Target
                ($)
              
              Maximum
                ($)
              
              Threshold
                (#)
              
              Target
                (#)
              
              Maximum
                (#)
              
              All
                  Other Stock Awards; Number of Shares of Stock or Units
                (#)
              
              All
                  Other Option Awards; Number of Securities Underlying Options
                (#)
              
              Exercise
                  or Base Price of Option Awards
                ($/Sh)
              
              Grant
                  Date Fair Value of Stock and Option AwardsRichard
                  Roger
              
              11/16/2006
              
              
              
              
              
              
              
              
              
              
              
              
              
              500,000
              
              
              
              
              
              $         0




On
      November 16, 2006, the Board of Directors approved the grant of 500,000 shares
      of restricted stock to Mr. Roger, pursuant to the terms of the Company’s 2004
      Stock Incentive Plan and Mr. Roger’s employment agreement. The terms of the
      award were that the shares were to be issued on January 1, 2007 with 166,667
      shares to vest on January 1, 2007, 166,667 shares to vest on January 1, 2008
      and
      166,666 shares to vest on January 1, 2009. The receipt of shares is contingent
      on Mr. Roger remaining employed by the Company on the date of vesting. Mr.
      Roger
      received his first award of 166,667 shares in January 2007. Pursuant to his
      employment agreement, Mr. Roger received a special bonus of $75,000 in January
      2007. In 2006, there was no FAS 123(R) expense for the grant of restricted
      stock.





There
      were no other stock based awards under the Stock Incentive Plan in 2006 to
      the
      Named Executive Officers.




26




**OUTSTANDING
      EQUITY AWARDS AT FISCAL YEAR END**





The
      following table sets forth the outstanding equity awards of the Named Executive
      Officers as of December 31, 2006.


**Outstanding
                  Equity Awards At Fiscal
                  Year-End**
  Option
                    Awards
              
              Stock
                    AwardsName
              
              No.
                    of Securities Underlying Unexercised Options (#)
                    Exercisable
              
              No.
                    of Securities Underlying Unexercised Options (#)
                    Unexercisable
              
              Equity
                    Incentive Plan Awards: No. of Securities Underlying Unexercised
                    Unearned
                    Options (#)
              
              Option
                    Exercise Price ($)
              
              Option
                    Expiration Date
              
              No.
                    of Shares or Units of Stock That Have Not Vested (#)
                    (4)
              
              Market
                    Value of Shares or Units of Stock That Have Not Vested
                  ($)
                    (5)
              
              Equity
                    Incentive Plan Awards: No. of Unearned Shares, Units or Other
                    Rights That
                    Have Not Vested (#)
              
              Equity
                    Incentive Plan Awards: Market or Payout Value of Unearned Shares,
                    Units or
                    Other Rights That Have Not Vested ($)Alan
                  RaeChief
                  Executive Officer
              
              
              1,250,000
              (1)
              
              
              
              
              
              
              $
              1.50
              
              
              7/14/2013Richard
                  Roger
              
              
              200,000
              (2)
              
              
              
              
              
              
              $
              1.50
              
              
              10/15/2014President
                  & COO
              
              
              631,250
              (2)
              
              618,750
              
              
              
              
              $
              1.50
              
              
              6/9/2015David
                  H. ShipmanChief
                  Financial Officer
              
              
              153,000
              (3)
              
              297,000
              
              
              
              
              $
              1.50
              
              
              10/1/2015




(1)
            Mr.
                Rae’s option vested 34% on July 15, 2004 and 16.5% every six months
                thereafter.


(2)
            Mr.
                Roger’s 200,000 option vested 100% upon his appointment at President and
                Chief Operating Officer. His 1,250,000 option vested 34% on July
                1, 2006
                and 16.5% every six months thereafter.


(3)
            Mr.
                Shipman’s option vested 34% on October 1, 2006 and 16.5% every six months
                thereafter.


(4)
            On
                November 16, 2006, the Board of Directors approved a grant of 500,000
                shares of restricted stock to Mr. Roger, pursuant to the terms of
                the
                Company’s 2004 Stock Incentive Plan and Mr. Roger’s employment agreement.
                The terms of the award were that the shares were to be issued on
                January
                1, 2007 with 166,667 shares to vest on January 1, 2007, 166,667 shares
                to
                vest on January 1, 2008 and 166,666 shares to vest on January 1,
                2009. The
                receipt of shares is contingent on Mr. Roger remaining employed by
                the
                Company on the date of vesting. Mr. Roger received his first award
                of
                166,667 shares in January 2007. Pursuant to his employment agreement,
                Mr.
                Roger received a special bonus of $75,000 in January
                2007.


(5)
            None
                of the 500,000 shares in Mr. Roger’s award were vested as of December 31,
                2006. The market value of these unvested shares on December 31, 2006
                was
                $410,000, based on the closing share price of $0.82 on December 29,
                2006,
                the last trading day of the year.





**OPTION
      EXERCISES AND STOCK VESTED**





**** There
      were no options exercised or stock vested during the year ended December 31,
      2006.





**PENSION
      BENEFITS AND NONQUALIFIED DEFERRED COMPENSATION**





The
      Company maintains a voluntary 401(k) plan for its employees and did not make
      any
      contributions in 2006. The Company does not maintain any other qualified
      retirement plans or non-nonqualified deferred compensation plans for its
      employees or directors.




**EMPLOYMENT
        AGREEMENTS AND CHANGE-IN-CONTROL ARRANGEMENTS**
 
 In
        July 2003, the Company entered into an Employment Agreement with Alan R.
        Rae, to serve as our President and Chief Executive Officer. Pursuant to the
        Employment Agreement, Mr. Rae is entitled to an annual base salary of
        $254,000 per year and is eligible to receive an annual bonus, at the discretion
        of the Board, of 100% of his base salary. He is also entitled to reimbursement
        for health insurance premiums and a car allowance. Pursuant to the agreement,
        the Company granted Mr. Rae 1,500,000 stock options at an exercise price of
        $1.50 per share in 2005, which were granted pursuant to the Company’s Stock
        Incentive Plan and were approved by the Board on September 29, 2005. On
        November 11, 2005, Mr. Rae relinquished his options to the Company to
        purchase 250,000 shares of common stock. The agreement continues in effect
        until
        terminated by either Mr. Rae or the Company by written notice or upon the
        death
        or disability of Mr. Rae. If the agreement is terminated by disability,
        Mr. Rae is entitled to receive his salary until he begins to receive
        disability benefits, to receive a prorated portion of any bonus he would
        otherwise have been entitled to receive and to be paid for any accrued but
        unused vacation. The agreement also provides that any inventions discovered
        by
        Mr. Rae during service to the Company shall be the property of the Company,
        and contains confidentiality, non-disparagement and non-competition
        provisions.
  On
        June 9, 2005, the Company entered into an Employment Agreement with Richard
        Roger to serve as our President and Chief Operating Officer. The terms of
        Mr. Rogers’ Employment Agreement are substantially similar to the terms of
        Mr. Rae’s Employment Agreement, as described above, except that
        Mr. Roger is entitled to an annual base salary of $250,000 per year and
        1,250,000 stock options, of which 1,000,000 shares were approved by the Board
        on
        September 29, 2005 and 250,000 shares were approved by the Board on
        November 11, 2005. The Board agreed if Mr. Roger leaves the Company
        before all of the additional 250,000 shares vest, the remaining unvested
        portion
        will be granted to the executive officer who relinquished these options.
        Effective July 2005, Mr. Roger was promised 500,000 shares of restricted
        stock at par value, vesting annually in equal amounts over three years
        commencing on January 1, 2007, with payment of the third award to be made
        on January 1, 2009.
 
 On
        July 28, 2005, the position of President was transferred from Mr. Rae
        to Mr. Richard Roger. Mr. Rae continues to serve as the Company’s
        Chief Executive Officer and Secretary.
 
 Effective
        October 1, 2005, the Company entered into an Employment Agreement with
        David H. Shipman to serve as our Chief Financial Officer. The terms of
        Mr. Shipman’s Employment Agreement are substantially similar to the terms
        of Mr. Rae’s Employment Agreement, as described above, except that
        Mr. Shipman is entitled to an annual base salary of $177,500 per year and
        450,000 stock options, which were approved by the Board on September 29,
        2005.
        On March 26, 2007, the Company amended David Shipman's employment agreement,
        increasing his salary to $210,000, effective as of January 1, 2007.
 
 Each
        of
        these employment agreements provides for certain compensation in the event
        of
        termination without cause or a change in control. In either event, the Company
        will (i) continue to make monthly payments of base salary and health insurance
        premiums for 12 months (15 months for Mr. Rae), (ii) pay a pro-rated bonus
        to
        which the executive would have otherwise been eligible, (iii) cause any unvested
        options granted to the executive to vest immediately, (iv) pay the executive
        for
        any unused accrued vacation time, and (v) reimburse the executive for expenses
        that would otherwise be entitled. In the case of Mr. Rae, the Company will
        reimburse his expenses reasonably incurred in connection with his and his
        family’s repatriation to the United Kingdom. In
        general, the employment agreement defines a change in control if
        more
        than fifty percent (50%) of the combined voting power of the continuing or
        surviving entity’s securities outstanding immediately after such merger,
        consolidation or other reorganization is owned by persons who were not
        stockholders of the Company immediately prior to such merger, consolidation
        or
        other reorganization.




27




**DIRECTOR
      COMPENSATION**





The
      following table sets forth the aggregate compensation paid or accrued by the
      Company to the Directors for the fiscal year ended December 31, 2006.




**Director
        Compensation**
  FeesEarned
                  orPaid
                  in
              
              
              
              Option
              
              Non-Equity
              
              Non
                  Qualified
              
              All
                  OtherCash
              
              Stock
              
              Awards
              
              Incentive
                  Plan
              
              Deferred
              
              CompensationName
              
              ($)
              
              Awards
              
              ($)
              
              Compensation
              
              Compensation
              
              ($)
              
              Total(2)
              
              ($)
              
              (3)(4)(5)
              
              ($)
              
              Earnings
              
              (6)
              
              ($)Arthur
                  E. Meyer
              
              $
              60,000
              
              
              
              
              $
              32,754
              
              
              
              
              
              
              
              
              
              
              $
              92,754ChairmanHendrik
                  Rethwilm
              
              $
              30,000
              
              
              
              
              $
              8,167
              
              
              
              
              
              
              
              
              
              
              $
              38,167Karim
                  Jobanputra
              
              $
              30,000
              
              
              
              
              $
              8,167
              
              
              
              
              
              
              
              
              
              
              $
              38,167David
                  L. Koontz
              
              $
              30,000
              
              
              
              
              $
              240,000
              
              
              
              
              
              
              
              $
              2,035
              
              $
              272,035E.
                  Holt Williams
              
              $
              37,917
              
              
              
              
              $
              16,377
              
              
              
              
              
              
              
              
              
              
              $
              54,294Jeffrey
                  L. Cornish
              
              $
              34,750
              
              
              
              
              $
              16,377
              
              
              
              
              
              
              
              
              
              
              $
              51,127Gerson
                  Santos-Leon
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              
              
              
              
              
              $
              0Alan
                Rae
                (1)
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              
              
              
              
              
              $
              0





(1)
            In
                addition to his position as the Chief Executive Officer, Mr. Rae
                serves on the Board of Directors, but does not receive any compensation
                as
                a Director. The compensation reflected in the Summary Compensation
                Table
                represents his total compensation for the year
                2006.





(2)
            In
                addition to his director fees, Mr. Williams was paid an additional
                $7,917
                for serving as the Audit Committee
                chairman.





In
      addition to his director fees, Mr. Cornish was paid an additional $4,750 for
      serving as the Compensation Committee chairman.





In
      addition to being a director of the Company, Mr. Gerson Santos Leon
      serves as the Director of R&D and Corporate Development for Abengoa
      Bioenergy R&D (“ABRD”). ABRD’s corporate policy states employees who serve
      as outside directors must assign all director compensation to ABRD. Accordingly,
      Mr. Santos Leon’s director’s fees for 2006 in the amount of $22,500 were paid
      directly to ABRD.





(3)
            These
                amounts reflect the dollar amount recognized for financial statement
                reporting purposes for the fiscal year ended December 31, 2006, in
                accordance with SFAS 123(R) for awards pursuant to the Stock Incentive
                Plan and thus may include amounts from awards granted in and prior
                to
                2006. Assumptions used in the calculation of these amounts are included
                in
                footnote 2 to the Company’s audited financial statements for the fiscal
                year ended December 31, 2006.




28




Options
      for these directors vest over the first three years of the ten-year option
      term,
      34% in the first year and 16.5% every six months thereafter.





(4)
            Mr.
                Meyer’s option vested 34% on May 31, 2006, and16.5%
                every six months thereafter.




Mr.
      Rethwilm’s option vested 34% on July 15, 2004, and
      16.5%
      every six months thereafter.




Mr.
      Jobanputra’s option vested
      34% on July 15, 2004, and
      16.5%
      every six months thereafter.




Mr.
      Koontz’s option vested 34% on July 15, 2004, and
      16.5%
      every six months thereafter.




Mr.
      Williams’ option vested 34% on May 31, 2006, and
      16.5%
      every six months thereafter.




Mr.
      Cornish’s option vested 34% on May 31, 2006, and
      16.5%
      every six months thereafter.


(5)
              As
                  of December 31, 2006, each director had outstanding options to
                  purchase
                  the indicated number of shares of the Company common stock: Arthur
                  E.
                  Meyer, 400,000; Hendrik Rethwilm, 750,000; Karim Jobanputra, 750,000;
                  David L. Koontz, 200,000; E. Holt Williams, 200,000; and Jeffrey
                  L.
                  Cornish, 200,000.


(6)
            In
                addition to his director fees, Mr. Koontz was paid an additional
                $2,035
                for tax advice requested by the
                Board.




Item 11.
      Security Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters




Equity
      Composition Plan Information





The
      following table provides information as of December 31, 2006 related to the
      equity compensation plans in effect at that time:





Plan
                Category
            
            Number
                  ofsecurities
                  to beissued
                  upon exerciseof
                  outstandingoptions,
                  warrantsand
                  rights
            
            Weighted-averageexercise
                  price ofoutstandingoptions,
                  warrantsand
                  rights
            
            Number
                  ofsecuritiesremaining
                  availablefor
                  future issuancesunder
                  equitycompensationplansEquity
                Compensation Plans approved by shareholders
            
            
            7,500,000
            
            $
            1.45
            
            
            2,250,000Equity
                Compensation Plans not approved by shareholders
            
            
            0
            
            
            0
            
            
            0Totals
            
            
            7,500,000
            
            $
            1.45
            
            
            2,250,000





The
      following table sets forth certain information as of December 31, 2006,
      regarding the beneficial ownership of the Company’s common stock by
      (i) those persons known to the Company to be the beneficial owners of more
      than 5% of the outstanding shares of Common Stock, (ii) each of the named
      executive officers, (iii) each director of the Company, and (iv) all
      current directors and executive officers as a group.





Beneficial
      ownership is determined in accordance with SEC rules computing the number of
      shares of common stock beneficially owned by a person and the percentage
      ownership of that person.





Except
      as
      indicated in the footnotes to this table, each stockholder named in the table
      below has sole voting and investment power for the shares shown as beneficially
      owned by them. Percentage of ownership is based on 76,431,001 shares of common
      stock outstanding
      on March 24, 2007. In computing the number of shares beneficially owned by
      a person and the percentage of ownership held by that person, shares of common
      stock subject to options held by that person that are currently exercisable
      or
      will become exercisable within 60 days after December 31, 2006 are deemed
      exercised and outstanding, while these shares are not deemed exercised and
      outstanding for computing percentage ownership of any other person.




29




**Directors,
                Officers and**
            
            **Shares
                Directly and****5%
                Shareholders**
            
            **Beneficially
                Owned**
            
            **Percent**Abengoa
                Bioenergy R&D Inc.
            
            
            9,273,102
            
            
            12.1
            %c/o
                Crochet & CrochetSquaidelile,
                Geneva, SwitzerlandUBS
                AG
            
            
            8,000,000
            
            
            10.5
            %100
                Liverpool StreetLondon
                EC2m2RHStandard
                Bank Plc
            
            
            5,000,000
            
            
            6.5
            %25
                Dowgate HillLondon
                EC4R 2SBAlan
                Rae (a)
            
            
            2,769,022
            
            
            3.6
            %100
                Commerce Drive, Suite 301Newark,
                Delaware 19713Richard
                Roger
            
            
            1,331,250
            
            
            1.7
            %100
                Commerce Drive, Suite 301Newark,
                Delaware 19713Karim
                Jobanputra
            
            
            754,000
            
            
            1.0
            %100
                Commerce Drive, Suite 301Newark,
                Delaware 19713Hendrik
                Rethwilm
            
            
            750,000
            
            
            1.0
            %100
                Commerce Drive, Suite 301Newark,
                Delaware 19713David
                Koontz
            
            
            290,512
            
            
            *100
                Commerce Drive, Suite 301Newark,
                Delaware 19713Arthur
                Meyer
            
            
            202,000
            
            
            *100
                Commerce Drive, Suite 301Newark,
                Delaware 19713David
                Shipman
            
            
            153,000
            
            
            *100
                Commerce Drive, Suite 301Newark,
                Delaware 19713E.
                Holt Williams
            
            
            142,395
            
            
            *100
                Commerce Drive, Suite 301Newark,
                Delaware 19713Jeffrey
                Cornish
            
            
            101,000
            
            
            *100
                Commerce Drive, Suite 301Newark,
                Delaware 19713




*
            
            Less
                than 1%.(a)
            
            A
                trust of which Mr. Rae is the beneficiary holds 819,787 shares, and
                Mrs. Victoria Rae (spouse), owns 699,235 shares of the Company’s
                common stock. Mr. Rae disclaims beneficial ownership of the shares
                held by the trust to the extent that they are not attributable to
                his
                proportionate interest in the trust. Mr. Rae also disclaims
                beneficial ownership of the shares held by Victoria
                Rae.




30




Item 12.
      Certain Relationships and Related Transactions, and Director
      Independence




**Review
      and Approval of Related Person Transactions.**





The
      Company has operated under a Code of Ethics for many years. The
      Company’s Code of Ethics requires all employees, officers and directors, without
      exception, to avoid engagement in activities or relationships that conflict,
      or
      would be perceived to conflict, with the Company’s interests or adversely affect
      its reputation. It is understood, however, that certain relationships or
      transactions may arise that would be deemed acceptable and appropriate upon
      full
      disclosure of the transaction, following review and approval to ensure there
      is
      a legitimate business reason for the transaction and that the terms of the
      transaction are no less favorable to the Company than could be obtained from
      an
      unrelated person.





The
      Audit
      Committee is responsible for reviewing and approving, as appropriate, all
      transactions with related persons. The Company has not adopted written
      procedures for reviewing related person transactions. The
      Company reviews all relationships and transactions in which the company and
      our
      directors and executive officers or their immediate family members are
      participants to determine whether such persons have a direct or indirect
      material interest. As required under SEC rules, transactions, if any, that
      are
      determined to be directly or indirectly material to the company or a related
      person are disclosed.





**Director
      Independence**





In
      accordance with AMEX rules, the Board affirmatively determines the independence
      of each Director and nominee for election as a Director in accordance with
      AMEX’s independence standards as set forth in Section 121A of the AMEX Company
      Guide. Based on these standards, at its meeting held on March 20, 2007, the
      Board determined that each of the following non-employee Directors is
      independent and has no relationship with the Company, except as a Director
      and
      stockholder of the Company: Mr. Meyer, Mr. Rethwilm, Mr. Williams, Mr. Cornish
      and Mr. Santos Leon.





Item
      13.
      Exhibits




(a) Exhibits




Exhibits
      included or incorporated by reference in this document are set forth in the
      Exhibit Index below.




EXHIBIT
      INDEX


**O2Diesel
        Corporation**
 **(A
        Development Stage Company)**
 **Description**3
              .1(1)
              
              Certificate
                  of Amendment, amending the Certificate of Incorporation3
              .2(2)
              
              Bylaws3
              .3(3)
              
              Certificate
                  of Eliminating Reference to the Company’s Series A Convertible Preferred
                  stock and Series B Convertible Preferred Stock from the Certificate
                  of
                  Incorporation of O2Diesel Corporation, dated December 6,
                  20064
              .1(4)
              
              Specimen
                  Stock Certificate10
              .1(5)
              
              Form
                  of Employment Agreement between O2Diesel Corporation and Alan
                  Rae*10
              .2(5)
              
              Cooperation
                  agreement between Cognis and AAE+10
              .3(6)
              
              Letter
                  dated September 23, 2003 from the California Air Resources
                  Board10
              .4(7)
              
              Convertible
                  Preferred Stock Purchase Agreement by and among O2Diesel Corporation
                  and
                  the Purchaser names therein, dated March 3, 200410
              .5(8)
              
              Convertible
                  Preferred Stock Purchase Agreement by and among O2Diesel Corporation
                  and
                  the Purchaser named therein, dated March 29, 2004.10
              .6(9)
              
              Form
                  of Subscription Agreement for $2.0 million Private Placement as
                  entered into by and between O2Diesel Corporation and each individual
                  investor10
              .7(9)
              
              Form
                  of Warrant for $2.0 and $3.0 million Private
                  Placements10
              .8(10)
              
              Form
                  of Subscription Agreement for $3.0 million Private Placement as
                  entered into by and between O2Diesel Corporation and each individual
                  investor.10
              .9(11)
              
              Employment
                  Agreement by and between O2Diesel Corporation and Richard
                  Roger*10
              .10(12)
              
              Common
                  Stock and Warrant Purchase Agreement between O2Diesel Corporation
                  and the
                  Purchaser named therein, dated September 20, 200510
              .11(12)
              
              Form
                  of Warrant for Purchaser.10
              .12(13)
              
              Employment
                  Agreement by and between O2Diesel Corporation and David
                  Shipman.*10
              .13(14)
              
              Form
                  of Warrant for Advisors10
              .14(15)
              
              Common
                  Stock and Warrant Purchase Agreement by and between O2Diesel Corporation
                  and Abengoa Bioenergy R&D, Inc.10
              .15(15)
              
              Commercial
                  Agreement by and between O2Diesel Corporation and Abengoa Bioenergy
                  R&D, Inc.10
              .16(15)
              
              Form
                  of Warrant for Abengoa Bioenergy R&D, Inc.10
              .17(16)
              
              Common
                  Stock and Warrant Purchase Agreement for $4.0 million Private
                  Placement10
              .18(16)
              
              Form
                  of Warrant for $4.0 million Private Placement10
              .19(17)
              
              Amendment
                  No. 1 to Common Stock and Warrant Purchase Agreement for $4.0 million
                  Private Placement10
              .17(16)
              
              Common
                  Stock and Warrant Purchase Agreement for $2.5 million Private
                  Placement10
              .18(16)
              
              Form
                  of Warrant for $2.5 million Private Placement10
              .19(17)
              
              Amendment
                  No. 1 to Common Stock and Warrant Purchase Agreement for $2.5 million
                  Private Placement10
              .20(18)
              
              Form
                  of Incentive Stock Option
                  Agreement*


31


10
            .21(19)
            
            Common
                Stock and Warrant Purchase Agreement+10
            .22(19)
            
            Supply
                and Distribution Agreement+10
            .23(19)
            
            Form
                of Warrant10
            .24(19)
            
            Form
                of Additional Warrant10
            .25(19)
            
            Amendment
                No. 1 to Common Stock and Warrant Purchase Agreement+10
            .26(20)
            
            Form
                of Restricted Stock Agreement*10
            .27
            
            Share
                Exchange Agreement, by and among O2Diesel Corporation, ProEnergy
                Company,
                Inc., and its shareholders (filed herewith)10
            .28(21)
            
            Common
                Stock Purchase Agreement, dated as of February 16, 2007, by and between
                O2Diesel Corporation and Fusion Capital Fund II, LLC10
            .29(21)
            
            Registration
                Rights Agreement, dated as of February 16, 2007, by and between O2Diesel
                Corporation and Fusion Capital Fund II, LLC10
            .30(23)
            
            O2Diesel
              Corporation 2004 Stock Incentive Plan, as amended.10
            .31
            
            Amendment
              No.
              1 to David Shipman's Employment Agreement (filed
              herewith)*10
            .32
            
            Supply
              and
              Distribution Agreement (filed herewith)+16
            .1(22)
            
            Letter
                of Ernst & Young LLP, dated March 23, 200621
            
            
            Subsidiaries
                of O2Diesel Corporation (filed herewith)23
            .1
            
            Consent
              of
              Ernst & Young LLP23
            .2
            
            Consent
              of
              Mayer Hoffman McCann P.C.31
            .1
            
            Certification
                of the Chief Executive Officer pursuant to Rule 13a-14(a) or
                Rule 15d-14(a), as adopted pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002 (filed herewith)31
            .2
            
            Certification
                of the Chief Financial Officer pursuant to Rule 13a-14(a) or
                Rule 15d-14(a), as adopted pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002 (filed herewith)32
            .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 (filed
                herewith)




32




(1)
            
            Previously
                filed as an exhibit to the Company’s quarterly report on Form 10-QSB for
                the quarter ended June 30, 2006, on August 14, 2006, and incorporated
                herein by reference.(2)
            
            Previously
                filed as an exhibit to the Company’s current report on Form 8-K on
                January 5, 2005, and incorporated herein by
                reference.(3)
            
            Previously
                filed as an exhibit to the Company’s current report on Form 8-K on
                December 11, 2006, and incorporated herein by
                reference.(4)
            
            Previously
                filed as an exhibit to the Company’s registration statement on Form SB-2
                on June 30, 2000, as amended September 19, 2000,
                November 3, 2000, and December 22, 2000, and incorporated herein
                by reference.(5)
            
            Previously
                filed as an exhibit to the Company’s current report on Form 8-K on
                July 30, 2003, and incorporated herein by
                reference.(6)
            
            Previously
                filed as an exhibit to the Company’s quarterly report on Form 10-QSB for
                the quarter ended September 30, 2003, on November 19, 2003, and
                incorporated herein by reference.(7)
            
            Previously
                filed as an exhibit to the Company’s current report on Form 8-K on
                March 12, 2004, and incorporated herein by
                reference.(8)
            
            Previously
                filed as an exhibit to the Company’s annual report on Form 10-KSB on
                March 30, 2004, and incorporated herein by
                reference.(9)
            
            Previously
                filed as an exhibit to the Company’s current report on Form 8-K on
                March 23, 2005, and incorporated herein by
                reference.(10)
            
            Previously
                filed as an exhibit to the Company’s current report on Form 8-K on
                June 16, 2005, and incorporated herein by
                reference.(11)
            
            Previously
                filed as an exhibit to the Company’s current report on Form 8-K on
                August 3, 2005, and incorporated herein by
                reference.(12)
            
            Previously
                filed as an exhibit to the Company’s current report on Form 8-K on
                October 4, 2005, and incorporated herein by
                reference.(13)
            
            Previously
                filed as an exhibit to the Company’s current report on Form 8-K on
                October 5, 2005, and incorporated herein by
                reference.(14)
            
            Previously
                filed as an exhibit to the Company’s current report on Form 8-K on
                October 28, 2005, and incorporated herein by
                reference.(15)
            
            Previously
                filed as an exhibit to the Company’s current report on Form 8-K on
                November 2, 2005, and incorporated herein by
                reference.(16)
            
            Previously
                filed as an exhibit to the Company’s current report on Form 8-K on April
                20, 2006, and incorporated herein by reference.(17)
            
            Previously
                filed as an exhibit to the Company’s current report on Form 8-K on
                April 27, 2006, and incorporated herein by
                reference.(18)
            
            Previously
                filed as an exhibit to the Company’s current report on Form 8-K/A on July
                28, 2006 and incorporated herein by reference.(19)
            
            Previously
                filed as an exhibit to the Company’s quarterly report on Form 10-QSB for
                the quarter ended September 30, 2006, on November 14, 2006, and
                incorporated herein by reference.(20)
            
            Previously
                filed as an exhibit to the Company’s current report on Form 8-K on
                December 19, 2006 and incorporated herein by reference.(21)
            
            Previously
                filed as an exhibit to the Company’s current report on Form 8-K on
                February 20, 2007 and incorporated herein by reference.(22)
            
            Previously
                filed as an exhibit to the Company’s current report on Form 8-K on March
                29, 2006, and incorporated herein by reference.(23)
            
            Previously
                filed as Annex C to the Company’s Proxy
                Statements filed in June 5, 2006, and incorporated herein by
                reference.


*
          Indicates a management contract or compensatory plan.
  +  Certain
          confidential material contained in the document has been omitted and filed
          separately with the Securities and Exchange Commission pursuant to Rule
          406 of
          the Securities Act of 1933, as amended or Rule 24b-2 of the Securities
          and
          Exchange Act of 1934, as amended.





**Item 14.
      Principal Accountant Fees and Services**




During
      our fiscal year ended December 31, 2005, Ernst & Young LLP served as
      the Company’s auditors and during our fiscal year ended December 31, 2006, Mayer
      Hoffman McCann P.C. served as the Company’s auditors. Following are the fees
      billed by Mayer Hoffman McCann P.C. for the fiscal year ended December 31,
      2006 and by Ernst & Young LLP for the fiscal year ended
      December 31, 2005:





**2006**
            
            **2005**Audit
                FeesMayer
                Hoffman McCann P.C.
            
            $
            16,292Ernst
                & Young LLP
            
            
            
            
            $
            260,000Tax
                FeesMayer
                Hoffman McCann P.C.
            
            $
            23,743Ernst
                & Young LLP
            
            
            
            
            $
            -Audit
                Related FeesMayer
                Hoffman McCann P.C.
            
            $
            86,189Ernst
                & Young LLP
            
            $
            18,346
            
            $
            137,000Total
                FeesMayer
                Hoffman McCann P.C.
            
            $
            126,224Ernst
                & Young LLP
            
            $
            18,346
            
            $
            397,000**$**
            **144,570**
            
            **$**
            **397,000**




33




**•**
            
            **“Audit
                fees”**are fees paid for professional services for the audit of our consolidated
                financial statements.**•**
            
            **“Tax
                fees”**are fees primarily for tax compliance in connection with filing US
                income
                tax returns in 2006 for the 2005 tax returns.**•**
            
            **“Audit
                Related fees”**are fees billed by Ernst & Young and Mayer Hoffman McCann P.C. to us
                for services not included in the first two categories, specifically,
                SAS 100 reviews, SEC filings and consents, and accounting
                consultations on matters addressed during the audit or interim reviews,
                and review work related to quarterly
                filings.




**Non-Audit
      Services**




The
      Audit Committee has considered the compatibility of non-audit services with
      the
      auditor’s independence. The Audit Committee pre-approves all audit and
      permissible non-audit services provided by our independent
      auditors.





SIGNATURES




Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act
      of 1934, the Registrant has duly caused this report to be signed on its behalf
      by the undersigned, thereunto duly authorized.




O2DIESEL
      CORPORATION


By:
            
            /s/
                Alan R. RaeAlan
                R. RaeChief
                Executive Officer and DirectorMarch 27,
                2007




SIGNATURES




Pursuant
      to the requirements of the Securities Exchange Act of 1934, this report has
      been
      signed below by the following persons in the capacities and on the dates
      indicated.




**TITLE**
            
            **DATE**/s/
                Alan R. Rae
            
            Director
                and Chief Executive Officer (Principal Executive Officer)
            
            March 27,
                  2007Alan
                R. Rae/s/
                David H. Shipman
            
            Chief
                Financial Officer (Principal Financial and Accounting
                Officer)
            
            March 27,
                  2007David
                H. Shipman/s/
                Arthur Meyer
            
            Chairman
            
            March 27,
                  2007Arthur
                Meyer/s/
                David L. Koontz
            
            Director
            
            March 27,
                  2007David
                L. Koontz/s/
                Karim Jobanputra
            
            Director
            
            March 27,
                  2007Karim
                Jobanputra/s/
                Hendrik Rethwilm
            
            Director
            
            March 27,
                  2007Hendrik
                Rethwilm/s/
                E. Holt Williams
            
            Director
            
            March 27,
                  2007E.
                Holt Williams/s/
                Jeffrey Cornish
            
            Director
            
            March 27,
                  2007Jeffery
                Cornish/s/
                Gerson Santos-Leon
            
            Director
            
            March 27,
                2007Gerson
              Santos-Leon


34
   **INDEX
          TO CONSOLIDATED FINANCIAL STATEMENTS**
  **PAGE****Reports
                    of Independent Registered Public Accounting Firms**
                
                **F-1****Consolidated
                    Balance Sheet as of December 31, 2006**
                
                **F-2****Consolidated
                    Statements of Operations for the years ended December 31, 2006 and
                    2005 and the period from October 14, 2000 (inception) through
                    December 31, 2006**
                
                **F-3****Consolidated
                    Statements of Changes in Stockholders’ Equity (Deficit) for the years
                    ended December 31, 2006 and 2005 and the period from October 14,
                    2000 (inception) through December 31,
                    2006**
                
                **F-4****Consolidated
                    Statements of Cash Flows for the years ended December 31, 2006 and
                    2005 and the period from October 14, 2000
                    (inception) through December 31, 2006**
                
                **F-6****Notes
                    to Consolidated Financial Statements**
                
                **F-7**
   35
 **REPORT
            OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**
 
 To
            the
            Board of Directors and Shareholders
 O2Diesel
            Corporation
 
 We
            have
            audited the accompanying consolidated balance sheet of O2Diesel Corporation
            (a
            development stage company) as of December 31, 2006 and the related consolidated
            statements of operations, changes in stockholders’ equity (deficit), and cash
            flows for the year then ended and for the period October 14, 2000 (inception)
            through December 31, 2006. These financial statements are the responsibility
            of
            the Company's management. Our responsibility is to express an opinion
            on these
            financial statements based on our audit.
 
 We
            conducted our audit in accordance with the standards of
            the
            Public Company Accounting Oversight Board (United States) .
            Those
            standards require that we plan and perform the audit to obtain reasonable
            assurance about whether the financial statements are free of material
            misstatement. The Company is not required to have, nor were we engaged
            to
            perform, an audit of its internal control over financial reporting. Our
            audit
            included consideration of internal control over financial reporting as
            a basis
            for designing audit procedures that are appropriate in the circumstances,
            but
            not for the purpose of expressing an opinion on the effectiveness of
            the
            Company’s internal control over financial reporting. Accordingly, we express
            no
            such opinion. An audit includes examining, on a test basis, evidence
            supporting
            the amounts and disclosures in the financial statements. An audit also
            includes
            assessing the accounting principles used and significant estimates made
            by
            management, as well as evaluating the overall financial statement presentation.
            We believe that our audit provides a reasonable basis for our
            opinion.
 
 In
            our
            opinion, the financial statements referred to above present fairly, in
            all
            material respects, the consolidated financial position of O2Diesel Corporation
            as of December 31, 2006, and the results of its operations and its cash
            flows
            for the year then ended and for the period October 14, 2000 (inception)
            through
            December 31, 2006, in conformity with U.S. generally accepted accounting
            principles.
 
 The
            accompanying financial statements have been prepared assuming the Company
            will
            continue as a going concern. As discussed in Note 1 to the consolidated
            financial statements, the Company’s accumulated losses and lack of available
            working capital raise substantial doubt about the Company’s ability to continue
            as a going concern. Management’s plans with regard to these matters are also
            described in Note 1. The 2006 financial statements do not include any
            adjustments that might result from the outcome of this uncertainty.
 
 
 /s/
            Mayer
            Hoffman McCann P.C.
 
 Plymouth
            Meeting, Pennsylvania
 March
            27,
            2007
 
 F-1
 **REPORT
              OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**
   The
            Board
            of Directors and
 Shareholders
            of O2Diesel Corporation
  We
            have
            audited the accompanying consolidated statements of operations, changes
            in
            stockholders’ equity (deficit), and cash flows of O2Diesel Corporation (a
            developmental stage company) for the year ended December 31, 2005 and for
            the period October 14, 2000 (inception) through December 31,
            2005. These financial statements are the responsibility of the Company’s
            management. Our responsibility is to express an opinion on these financial
            statements based on our audits.
  We
            conducted our audits in accordance with the standards of the Public Company
            Accounting Oversight Board (United States). Those standards require that
            we plan
            and perform the audit to obtain reasonable assurance about whether the
            financial
            statements are free of material misstatement. We were not engaged to
            perform an
            audit of the Company’s internal control over financial reporting. Our audit
            included consideration of internal control over financial reporting as
            a basis
            for designing audit procedures that are appropriate in the circumstances,
            but
            not for the purpose of expressing an opinion on the effectiveness of
            the
            Company’s internal control over financial reporting. Accordingly, we express
            no
            such opinion. An audit also includes examining, on a test basis, evidence
            supporting the amounts and disclosures in the financial statements, assessing
            the accounting principles used and significant estimates made by management,
            and
            evaluating the overall financial statement presentation. We believe that
            our
            audits provide a reasonable basis for our opinion.
  In
            our
            opinion, the financial statements referred to above present fairly, in
            all
            material respects, the consolidated results of operations and cash flows
            of
            O2Diesel Corporation for the year ended December 31, 2005 and for the
            period October 14, 2000 (inception) through December 31, 2005, in
            conformity with U.S. generally accepted accounting principles.
  The
            accompanying financial statements have been prepared assuming the Company
            will
            continue as a going concern. As discussed in Note 1 to the consolidated
            financial statements, the Company’s accumulated losses and lack of available
            working capital raise substantial doubt about the Company’s ability to continue
            as a going concern. Management’s plans with regard to these matters are also
            described in Note 1. The 2005 financial statements do not include any
            adjustments that might result from the outcome of this uncertainty.
 
 /s/
            Ernst
& Young LLP
 Philadelphia,
            Pennsylvania
 March
            31,
            2006
  F-2
  **O2Diesel
          Corporation**
 **(A
          Development Stage Company)**
 **Consolidated
          Balance Sheet**
 **December 31,
          2006**
 **ASSETS****CURRENT
                      ASSETS**Cash
                  
                  $
                  3,065,630Restricted
                      cash
                  
                  
                  3,644,427Accounts
                      receivable
                  
                  
                  13,775Due
                      from related parties
                  
                  
                  36,040Other
                      receivables
                  
                  
                  732,587Inventory
                  
                  
                  157,598Prepaid
                      expenses, parts and deposits
                  
                  
                  316,353Total
                      current assets
                  
                  
                  7,966,410**FURNITURE
                      AND EQUIPMENT**Office
                      furniture and equipment
                  
                  
                  205,713Fuel
                      and test equipment
                  
                  
                  213,350419,063Less
                      accumulated depreciation
                  
                  
                  (188,876
                  )230,187**TOTAL
                      ASSETS**
                  
                  ***$***
                  ***8,196,597*****LIABILITIES
                      AND STOCKHOLDERS' EQUITY****CURRENT
                      LIABILITIES**Accounts
                      payable
                  
                  $
                  549,892Accrued
                      expenses
                  
                  
                  386,667Due
                      to related parties
                  
                  
                  141,161Deferred
                      grants
                  
                  
                  9,959Deferred
                      marketing program
                  
                  
                  234,500Other
                      current liabilities
                  
                  
                  6,562Total
                      current liabilities
                  
                  
                  1,328,741**TOTAL
                      LIABILITIES**
                  
                  
                  **1,328,741****STOCKHOLDERS'
                      EQUITY**Preferred
                      stock: par value of $0.0001; 20,000,000 shares authorized;none
                      issued and outstanding
                  
                  
                  -Common
                      stock: par value of $0.0001; 135,000,000 shares
                      authorized;75,125,014
                      issued and outstanding
                  
                  
                  7,513Additional
                      paid-in capital
                  
                  
                  40,076,305Unearned
                      compensation
                  
                  
                  (125,141
                  )Accumulated
                      other comprehensive loss
                  
                  
                  (4,381
                  )Deficit
                      accumulated during the development stage
                  
                  
                  (33,086,440
                  )Total
                      stockholders' equity
                  
                  
                  6,867,856**TOTAL
                      LIABILITIES AND STOCKHOLDERS' EQUITY**
                  
                  ***$***
                  ***8,196,597***
 
 See
          Notes
          to Consolidated Financial Statements
 
 F-3
  **O2Diesel
          Corporation**
 **(A
          Development Stage Company)**
 **Consolidated
          Statements of Operations**
 October
                      14, 2000Year
                      ended
                  
                  Year
                      ended
                  
                  (inception)
                    throughDecember
                      31,
                  
                  December
                      31,
                  
                  December
                      31,2006
                  
                  2005
                  
                  2006**Revenue:**Additive
                      related sales
                  
                  $
                  167,063
                  
                  $
                  131,605
                  
                  $
                  438,323Sponsorship
                      income
                  
                  
                  83,871
                  
                  
                  64,002
                  
                  
                  147,873250,934
                  
                  
                  195,607
                  
                  
                  586,196**Expenses:**Cost
                      of goods sold
                  
                  
                  119,367
                  
                  
                  101,277
                  
                  
                  326,307Selling
                      and marketing
                  
                  
                  1,217,731
                  
                  
                  1,987,537
                  
                  
                  7,846,854Product
                      testing and government grants, net
                  
                  
                  (394,982
                  )
                  
                  438,086
                  
                  
                  977,783General
                      and administrative
                  
                  
                  7,416,679
                  
                  
                  4,468,957
                  
                  
                  25,549,030**Total
                      operating expense**
                  
                  
                  8,358,795
                  
                  
                  6,995,857
                  
                  
                  34,699,974**Operating
                      loss**
                  
                  
                  **(8,107,861**
                  **)**
                  
                  **(6,800,250**
                  **)**
                  
                  **(34,113,778**
                  **)****Other
                      income (expense):**Interest
                      expense
                  
                  
                  (8,223
                  )
                  
                  (10,621
                  )
                  
                  (122,523
                  )Interest
                      income
                  
                  
                  126,543
                  
                  
                  32,346
                  
                  
                  195,366Foreign
                      currency gain/(loss), net
                  
                  
                  395,104
                  
                  
                  (48,981
                  )
                  
                  498,783Other
                      (expense)/income, net
                  
                  
                  (13,718
                  )
                  
                  (24,659
                  )
                  
                  310,070**Total
                      other income (expense)**
                  
                  
                  499,706
                  
                  
                  (51,915
                  )
                  
                  881,696**Loss
                      before provision (benefit) for income taxes**
                  
                  
                  (7,608,155
                  )
                  
                  (6,852,165
                  )
                  
                  (33,232,082
                  )Benefit
                      for income taxes
                  
                  
                  -
                  
                  
                  -
                  
                  
                  145,642**Net
                      loss**
                  
                  
                  **(7,608,155**
                  **)**
                  
                  **(6,852,165**
                  **)**
                  
                  **(33,086,440**
                  **)****Deemed
                      dividend to preferred stockholders**
                  
                  
                  **(5,581,133**
                  **)**
                  
                  **(618,872**
                  **)**
                  
                  **(6,200,005**
                  **)****Net
                      loss allocable to common stockholders**
                  
                  **$**
                  **(13,189,288**
                  **)**
                  **$**
                  **(7,471,037**
                  **)**
                  **$**
                  **(39,286,445**
                  **)**Net
                      loss per common share(basic
                      and diluted)
                  
                  $
                  (0.20
                  )
                  $
                  (0.22
                  )
                  $
                  (1.28
                  )Weighted
                      average shares of commonshares
                      outstanding
                  
                  
                  65,723,876
                  
                  
                  34,726,991
                  
                  
                  51,847,176Recapitalization
                      resulting from the AAETechnologies
                      International PLC acquisition
                  
                  
                  -
                  
                  
                  -
                  
                  
                  21,212,951Weighted
                      average shares of commonshares
                      outstanding - giving effect to therecapitalization
                  
                  
                  65,723,876
                  
                  
                  34,726,991
                  
                  
                  30,634,225
  See
          Notes
          to Consolidated Financial Statements
  F-4
  **O2Diesel
          Corporation**
 **(A
          Development Stage Company)**
 **Consolidated
          Statements of Changes in Stockholders’ Equity (Deficit)**
 **for
          the years ended December 31, 2006 and 2005 and the**
 **Period
          from October 14, 2000 (inception) through December 31,
          2006**
 Common
                    
                    AdditionalPreferred
                        Stock
                    
                    Common
                        Stock
                    
                    Unearned
                    
                    Stock
                    
                    Paid
                        - InShares
                    
                    Amount
                    
                    Shares
                    
                    Amount
                    
                    Compensation
                    
                    Subscribed
                    
                    CapitalBalance
                        at October 14, 2000 (Inception)Common
                        stock issued in exchange for interest in wholly owned
                        subsidiaries
                    
                    
                    -
                    
                    $
                    -
                    
                    
                    43,008,772
                    
                    $
                    430,088
                    
                    $
                    -
                    
                    $
                    -
                    
                    $
                    3,603,415Net
                        loss
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -Foreign
                        currency translation adjustment
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -Comprehensive
                        loss
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -Common
                        stock issued on various dates during 2001
                    
                    
                    -
                    
                    
                    -
                    
                    
                    24,181,038
                    
                    
                    241,810
                    
                    
                    -
                    
                    
                    -
                    
                    
                    1,268,031Balance
                        at December 31, 2001
                    
                    
                    -
                    
                    
                    -
                    
                    
                    67,189,810
                    
                    
                    671,898
                    
                    
                    -
                    
                    
                    -
                    
                    
                    4,871,446Net
                        loss
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -Foreign
                        currency translation adjustment
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -Comprehensive
                        loss
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -Common
                        stock issued at $0.225 per share on various dates during
                        2002
                    
                    
                    -
                    
                    
                    -
                    
                    
                    703,282
                    
                    
                    7,033
                    
                    
                    -
                    
                    
                    -
                    
                    
                    515,657Balance
                        at December 31, 2002
                    
                    
                    -
                    
                    
                    -
                    
                    
                    67,893,092
                    
                    
                    678,931
                    
                    
                    -
                    
                    
                    -
                    
                    
                    5,387,103Net
                        loss
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -Foreign
                        currency translation adjustment
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -Comprehensive
                        loss
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -Common
                        stock issued on various dates during 2003
                    
                    
                    -
                    
                    
                    -
                    
                    
                    555,556
                    
                    
                    5,556
                    
                    
                    -
                    
                    
                    -
                    
                    
                    119,444Common
                        stock issued for consulting services
                    
                    
                    -
                    
                    
                    -
                    
                    
                    200,000
                    
                    
                    2,000
                    
                    
                    -
                    
                    
                    -
                    
                    
                    43,000Common
                        stock issued for remaining interest in subsidiaries on July
                        15,
                        2003
                    
                    
                    -
                    
                    
                    -
                    
                    
                    4,356,200
                    
                    
                    43,562
                    
                    
                    -
                    
                    
                    -
                    
                    
                    46,323Common
                        stock issued upon exercise of stock options on various dates
                        during
                        2003
                    
                    
                    -
                    
                    
                    -
                    
                    
                    8,670,881
                    
                    
                    86,709
                    
                    
                    -
                    
                    
                    -
                    
                    
                    1,131,595Recapitalization
                        resulting from AAE acquisition on July 15, 2003
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (56,928,690
                    )
                    
                    (814,283
                    )
                    
                    -
                    
                    
                    -
                    
                    
                    814,283Common
                        stock issued at $1.50 per share on various dates during
                        2003
                    
                    
                    -
                    
                    
                    -
                    
                    
                    3,333,333
                    
                    
                    333
                    
                    
                    -
                    
                    
                    -
                    
                    
                    4,999,667Expenses
                        related to 2003 issuance of common stock and
                        recapitalization
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (795,650
                    )Subscriptions
                        for 754,900 shares of common stock at $1.50 per share on
                        various dates
                        during 2003
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    1,132,350
                    
                    
                    -Balance
                        at December 31, 2003
                    
                    
                    -
                    
                    
                    -
                    
                    
                    28,080,372
                    
                    
                    2,808
                    
                    
                    -
                    
                    
                    1,132,350
                    
                    
                    11,745,765Net
                        loss
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -Foreign
                        currency translation adjustment
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -Comprehensive
                        loss
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -Common
                        stock issued at $1.50 per share on various dates in 2004
                    
                    
                    -
                    
                    
                    -
                    
                    
                    1,070,451
                    
                    
                    107
                    
                    
                    -
                    
                    
                    (1,132,350
                    )
                    
                    1,535,770Preferred
                        stock issued on various dates during 2004
                    
                    
                    1,550,000
                    
                    
                    155
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    5,478,609Balance
                        at December 31, 2004
                    
                    
                    1,550,000
                    
                    
                    155
                    
                    
                    29,150,823
                    
                    
                    2,915
                    
                    
                    -
                    
                    
                    -
                    
                    
                    18,760,144Net
                        loss
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -Foreign
                        currency translation adjustment
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -Comprehensive
                        loss
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -Common
                        stock issued for consulting services
                    
                    
                    -
                    
                    
                    -
                    
                    
                    63,750
                    
                    
                    6
                    
                    
                    -
                    
                    
                    -
                    
                    
                    63,094Warrants
                        issued for consulting services 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)**
 **for
            the years ended December 31, 2006 and 2005 and the**
 **Period
            from October 14, 2000 (inception) through December 31,
            2006**
 DeficitCommon
                    
                    Accumulated
                    
                    Accumulated
                    
                    TotalStock
                    
                    Other
                    
                    During
                        the
                    
                    Stockholders'Subscriptions
                    
                    Comprehensive
                    
                    Development
                    
                    EquityReceivable
                    
                    Income
                        (Loss)
                    
                    Stage
                    
                    (Deficit)Balance
                        at October 14, 2000 (Inception)Common
                        stock issued in exchange for interest in wholly owned
                        subsidiaries
                    
                    $
                    -
                    
                    $
                    -
                    
                    $
                    (4,138,684
                    )
                    $
                    (105,181
                    )Net
                        loss
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (1,406,709
                    )
                    
                    (1,406,709
                    )Foreign
                        currency translation adjustment
                    
                    
                    -
                    
                    
                    (4,476
                    )
                    
                    -
                    
                    
                    (4,476
                    )Comprehensive
                        loss
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (1,411,185
                    )Common
                        stock issued on various dates during 2001
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    1,509,841Balance
                        at December 31, 2001
                    
                    
                    -
                    
                    
                    (4,476
                    )
                    
                    (5,545,393
                    )
                    
                    (6,525
                    )Net
                        loss
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (1,712,803
                    )
                    
                    (1,712,803
                    )Foreign
                        currency translation adjustment
                    
                    
                    -
                    
                    
                    (74,085
                    )
                    
                    -
                    
                    
                    (74,085
                    )Comprehensive
                        loss
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (1,786,888
                    )Common
                        stock issued at $0.225 per share on various dates during
                        2002
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    522,690Balance
                        at December 31, 2002
                    
                    
                    -
                    
                    
                    (78,561
                    )
                    
                    (7,258,196
                    )
                    
                    (1,270,723
                    )Net
                        loss
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (4,230,296
                    )
                    
                    (4,230,296
                    )Foreign
                        currency translation adjustment
                    
                    
                    -
                    
                    
                    179,689
                    
                    
                    -
                    
                    
                    179,689Comprehensive
                        loss
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (4,050,607
                    )Common
                        stock issued on various dates during 2003
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    125,000Common
                        stock issued for consulting services
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    45,000Common
                        stock issued for remaining interest in subsidiaries on July
                        15,
                        2003
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (409,614
                    )
                    
                    (319,729
                    )Common
                        stock issued upon exercise of stock options on various dates
                        during
                        2003
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    1,218,304Recapitalization
                        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
                    )
                    
                    140,776Net
                        loss
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (6,852,165
                    )
                    
                    (6,852,165
                    )Foreign
                        currency translation adjustment
                    
                    
                    -
                    
                    
                    2,329
                    
                    
                    -
                    
                    
                    2,329Comprehensive
                        loss
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (6,849,836
                    )Common
                        stock issued for consulting services 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-6
  **O2Diesel
          Corporation**
 **(A
          Development Stage Company)**
 **Consolidated
          Statements of Cash Flows**
 October
                      14, 2000Years
                      Ended December 31,
                  
                  (inception)
                      through2006
                  
                  2005
                  
                  December
                      31, 2006**Cash
                      flows from operating activites****Net
                      loss**
                  
                  **$**
                  **(7,608,155**
                  **)**
                  **$**
                  **(6,852,165**
                  **)**
                  **$**
                  **(33,086,440**
                  **)**Adjustments
                      to reconcile loss to net cash used in operating activites:Depreciation
                  
                  
                  87,127
                  
                  
                  72,557
                  
                  
                  283,764Amortization
                  
                  
                  -
                  
                  
                  -
                  
                  
                  7,786Write
                      off of patent
                  
                  
                  -
                  
                  
                  -
                  
                  
                  337,329Write
                      off of obsolete inventory
                  
                  
                  -
                  
                  
                  5,925
                  
                  
                  5,925Loss(Gain)
                      on sale/disposal of furniture & equipment
                  
                  
                  18,044
                  
                  
                  (11,054
                  )
                  
                  8,528Non
                      cash contributions
                  
                  
                  5,312
                  
                  
                  -
                  
                  
                  5,312Common
                      stock and warrants issued for consulting services
                  
                  
                  51,000
                  
                  
                  158,100
                  
                  
                  254,100Amortization
                      of unearned compensation
                  
                  
                  1,727,574
                  
                  
                  -
                  
                  
                  1,727,574Changes
                      in operating assets and liabilites:Accounts
                      receivable
                  
                  
                  (275
                  )
                  
                  2,644
                  
                  
                  (13,775
                  )Due
                      from/(to) related parties
                  
                  
                  (13,604
                  )
                  
                  (17,774
                  )
                  
                  105,121Other
                      receivables
                  
                  
                  (613,286
                  )
                  
                  21,869
                  
                  
                  (732,587
                  )Inventory,
                      prepaid expenses and other current assets
                  
                  
                  (74,347
                  )
                  
                  (104,865
                  )
                  
                  (479,876
                  )Accounts
                      payable
                  
                  
                  (54,432
                  )
                  
                  14,578
                  
                  
                  549,892Accrued
                      expenses
                  
                  
                  124,194
                  
                  
                  (514,840
                  )
                  
                  386,667Deferred
                      grants
                  
                  
                  (286,137
                  )
                  
                  158,054
                  
                  
                  9,959Deferred
                      marketing program
                  
                  
                  (172,533
                  )
                  
                  407,033
                  
                  
                  234,500Other
                      current liabilities
                  
                  
                  6,562
                  
                  
                  (95,321
                  )
                  
                  (4,596
                  )**Cash
                      flows used in operating activities**
                  
                  
                  **(6,802,956**
                  **)**
                  
                  **(6,755,259**
                  **)**
                  
                  **(30,400,817**
                  **)****Cash
                      flows from investing activities**Restricted
                      cash
                  
                  
                  (91,267
                  )
                  
                  (3,553,160
                  )
                  
                  (3,644,427
                  )Purchase
                      of furniture and equipment
                  
                  
                  (137,752
                  )
                  
                  (7,096
                  )
                  
                  (528,881
                  )Proceeds
                      from sale of furniture & equipment
                  
                  
                  1,250
                  
                  
                  11,900
                  
                  
                  13,150Purchase
                      of patent
                  
                  
                  -
                  
                  
                  -
                  
                  
                  (345,115
                  )**Cash
                      flows used in investing activities**
                  
                  
                  **(227,769**
                  **)**
                  
                  **(3,548,356**
                  **)**
                  
                  **(4,505,273**
                  **)****Cash
                      flows from financing activities**Net
                      proceeds from issuance of preferred stock
                  
                  
                  -
                  
                  
                  -
                  
                  
                  5,478,764Net
                      proceeds from private placement
                  
                  
                  -
                  
                  
                  -
                  
                  
                  5,953,757Net
                      proceeds from issuance of common stock
                  
                  
                  8,694,798
                  
                  
                  10,570,002
                  
                  
                  26,550,493(Repayments)
                      / borrowings of bank debt
                  
                  
                  -
                  
                  
                  (22,104
                  )
                  
                  -**Cash
                      flows provided by financing activities**
                  
                  
                  **8,694,798**
                  
                  
                  **10,547,898**
                  
                  
                  **37,983,014**Effect
                      of exchange rate changes on cash
                  
                  
                  (11,294
                  )
                  
                  (3,682
                  )
                  
                  (11,294
                  )**Net
                      increase in cash**
                  
                  
                  **1,652,779**
                  
                  
                  **240,601**
                  
                  
                  **3,065,630****Cash
                      at beginning of period**
                  
                  
                  **1,412,851**
                  
                  
                  **1,172,250**
                  
                  
                  **-****Cash
                      at end of period**
                  
                  **$**
                  **3,065,630**
                  
                  **$**
                  **1,412,851**
                  
                  **$**
                  **3,065,630**Cash
                      paid for interest
                  
                  $
                  8,223
                  
                  $
                  8,248
                  
                  $
                  113,171Cash
                      paid for income taxes
                  
                  
                  None
                  
                  
                  None
                  
                  
                  None
  Non-cash
          transactions: Conversion of Bridge loan to common stock at 9/30/2003,
          $2,322,500.
 Conversion
          of preferred to common stock at various dates during 2006,
          $1,550,000.
  See
          Notes
          to Consolidated Financial Statements
  F-7
  **O2Diesel
          Corporation**
 **(A
          Development Stage Company)**
 **Notes
          to Consolidated Financial Statements**
  1.
          The
          Company and Basis of Presentation
  The
          Company
  O2Diesel
          Corporation (“O2Diesel” or the “Company”) is in the development stage and has
          developed a proprietary additive product designed to enable distillate
          liquid
          transportation fuels to burn cleaner by facilitating the addition of ethanol
          as
          an oxygenate to these fuels. To date, the Company’s operations have continued to
          be focused on raising capital, performing research and development, and
          bringing
          its product to market.
  O2Diesel’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 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 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 cost 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.
  O2Diesel
          was reincorporated in the state of Delaware in a transaction that became
          effective on December 31, 2004.
  Basis
          of
          presentation
  The
          Company’s consolidated financial statements for the year ended December 31,
          2006, have been prepared on a going concern basis, which contemplates the
          realization of assets and the settlement of liabilities and commitments
          in the
          normal course of business. At December 31, 2006, the Company had a working
          capital surplus of $6,637,669 and has accumulated losses of $33,086,440
          however
          $3,644,427 of the working capital is restricted in use to operational costs
          associated with developing markets in Europe.
  In
          December 2004, the Company was notified by the AMEX that it was not in
          compliance with the Exchange’s listing standards. Specifically, because of
          continuing losses and the fact that our shareholders’ equity had fallen below
          $2.0 million, we had failed to meet the required listing
          standards.
  In
          accordance with the procedures of the Exchange, we filed a plan (“Plan”) with it
          to demonstrate the steps we shall take to return to full compliance. On
          February 15, 2005, the AMEX notified us that it had accepted our Plan, and
          that we would be given until June 2006 in which to regain compliance with
          the Exchange’s listing standards. During this period, we were subject to
          periodic reviews by the AMEX to confirm that we were meeting the goals
          set forth
          in our Plan. As of June 2006, our shareholders’ equity was required to be
          $6.0 million or more in order for us to be in compliance with the
          Exchange’s listing rules. To achieve that level of stockholder’s equity, we
          anticipated having to raise a total of approximately $10.0 million in new
          equity during 2005. In December 2005, the Company determined that it could
          not meet certain conditions of the plan and met with representatives of
          the AMEX
          to discuss the need to develop an amended plan to demonstrate how the Company
          would be in compliance by June 2006.
  In
          the
          amended plan developed by the Company, management indicated that if it
          were to
          be successful in raising $7.0 million prior to June, 2006 and an additional
          $3.5
          million in equity in the second half of 2006, it would have sufficient
          cash to
          execute its business plan through December 31, 2006, and to be in
          compliance with the listing standards of the AMEX by
          June 2006.
  As
          described later in this section, the Company collected $592,692 (after
          expenses)
          and $865,452 (net of expenses) in two warrant exercises and closed three
          private
          placements totaling $7.5 million as part of this effort. The consolidated
          financial statements in this report do not include any adjustments to reflect
          other 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.
  If
          the
          Company were to fail to return to full compliance with the Exchange’s listing
          standards, the AMEX would likely initiate procedures to de-list its common
          stock. If the Company’s common stock were to be de-listed by the AMEX, its
          shares would continue to be traded as a bulletin board stock. On July 17,
          2006,
          the Company received a letter from the AMEX indicating that the Company
          had
          regained compliance with AMEX listing requirements.
  At
          December 31, 2006, the Company was in compliance with AMEX listing requirements. The Company believes that it will not be able to
          meet the
          AMEX listing requirements for equity as of the end of the first quarter of
          2007. However, as described in the Subsequent Events section (Note 11 to
          the
          Fiancial Statements), the Company has entered into a common stock purchase
          agreement to raise up to $10 million in new equity in 2007, which we believe
          will enable us to meet or exceed these requirements, once the registration
          statement for such shares is effective.
 
 2.
          Summary of Significant Accounting Policies
  Principles
          of Consolidation
  The
          consolidated financial statements include the accounts of the Company and
          all
          affiliated subsidiaries. All significant inter-company balances and transactions
          have been eliminated in consolidation.
  Cash
          and
          Cash Equivalents
  The
          Company considers all highly liquid instruments with a maturity of three
          months
          or less at the time of issuance to be cash equivalents. As of December
          31, 2006,
          cash deposits exceeded federally insured limits which are generally $100,000
          per
          financial institution.
 
 F-8
  **O2Diesel
          Corporation**
 **(A
          Development Stage Company)**
 **Notes
          to Consolidated Financial Statements**
 
 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.
          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, due
          to/from
          related parties, other receivables, accounts payable, accrued expenses,
          deferred
          marketing program accruals, and deferred grants 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 condition. Past-due or
          delinquency status is based upon the credit terms of 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 to the allowance
          for doubtful accounts when collection appears unlikely.
  Inventories
  Inventories,
          consisting of fuel additive held at third party locations, are stated at
          the
          lower of cost as determined using the first in, first out (FIFO) method, or
          market value.
 
 Furniture
          and Equipment and Depreciation
  Furniture
          and equipment are stated at cost, less accumulated depreciation. Depreciation
          is
          provided over the estimated useful lives of the assets on a straight-line
          basis.
          The estimated useful lives of fixed assets are as follows:
  Office
                    furniture and equipment
                
                3
                    to 5 yearsFuel
                    and test equipment
                
                5 years
  Depreciation
          expense recorded in the accompanying Consolidated Statements of Operations
          was
          $87,127, $72,557 and $283,764 for the years ending December 31, 2006, and
          2005, and the period October 14, 2000 (inception) through
          December 31, 2006.
  Accounting
          for Impairment of Long-Lived Assets
  The
          carrying value of intangible assets and other long-lived assets are reviewed
          on
          a regular basis for the existence of facts or circumstances that may suggest
          impairment. The Company recognizes impairment when the sum of the expected
          undiscounted future cash flows is less than the carrying amount of the
          asset.
          Impairment losses, if any, are measured as the excess of the carrying amount
          of
          the asset over its estimated fair value.
 
 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 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. Sponsorship fees will become additional revenue for
          us and
          will be recognized as such when a sponsorship agreement is signed and the
          fees
          have been invoiced and payment is assured. Costs that are intended to be
          supported by the sponsorship fees are recorded separately in the related
          expense
          line in our statement of operations. With regard to the advertising space,
          since
          the CityHomeTM program is still in 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 December 31, 2006, costs remaining to be amortized for
          CityHomeTM
programs were recorded on the balance sheet as Deferred Marketing Program
          in the
          amount of $234,500. The Company recorded $251,762, $869,974 and $1,121,736
          in
          costs for the CityHomeTM initiatives in excess of sponsorship fees during the
          years ended December 31, 2006, December 31, 2005 and the period October
          14, 2000
          (inception) through December 31, 2006, respectively.
  F-9
  **O2Diesel
          Corporation**
 **(A
          Development Stage Company)**
 **Notes
          to Consolidated Financial Statements**
 
 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 for the years ended December 31, 2006, and 2005, and the
          period October 14, 2000, (inception) through December 31, 2006,
          were $14,600, $10,653 and $51,692, respectively.
 
 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 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.
 
 Advertising
          Expenses
  Advertising
          costs are expensed as incurred. Advertising expense was $0, $0 and $450,000
          for
          the years ending December 31, 2006, and 2005, and the period
          October 14, 2000 (inception) through December 31, 2006,
          respectively.
 
 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 common 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 common share is the same since the effect
          of
          the dilutive securities is anti-dilutive.
 
 Accounting
          for Stock-Based Compensation
  In
          December 2004, the Financial Accounting Standards Board (the “FASB”) issued
          SFAS No. 123 (revised 2004), “Share-Based Payment” (SFAS No. 123(R)), which
          replaces SFAS No. 123 and supersedes APB Opinion No. 25. SFAS No
          123(R) requires all share-based payments to employees, including grants
          of
          employee stock options, to be recognized in the financial statements based
          on
          their fair values beginning with the first interim period after
          December 15, 2005, with early adoption encouraged. The pro forma
          disclosures previously permitted under SFAS No. 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 No. 123(R), using the modified prospective transition method. As
          a
          result, the Company's net loss before taxes is $1,727,574 for the year
          ended
          December 31, 2006 and for the period October 14, 2000 (inception) through
          December 31, 2006 higher than if it had continued to account for share-based
          compensation under Accounting Principles Board (“APB”) opinion
          No. 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 FASB Statement No. 123,
“Accounting for Stock -Based Compensation”, (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
          Opinion 25 for certain options granted to non-employees of the Company
          based
          upon the intrinsic value.
 
 The
          Company implemented a Stock Incentive Plan (the “Incentive Plan”) in 2004 for
          which the Board of Directors has authorized 7,212,957 shares of common
          stock to
          be reserved for future issuance under the Plan. At December 31, 2005, the
          Company had committed to award 7,750,000 options to purchase common stock
          to
          certain officers, employees and directors, of which 5,950,000 options had
          been
          approved and granted by the Board of Directors. As of June 30, 2006, one
          employee who had been promised (but not granted) 600,000 options left the
          employment of the Company and forfeited the promised options. Four other
          employees received new promises for 350,000 options, resulting in net
          commitments from the Company of 7,500,000 options to purchase common stock.
          The
          Company obtained approval from the shareholders at the annual meeting on
          July 6,
          2006 to increase the number of common shares available for issuance under
          the
          Incentive Plan in order to effectuate the grant of the remaining stock
          options
          promised to plan participants. Subsequent to this approval, the Board of
          Directors granted the promised 350,000 options and an additional 1,200,000
          options to six other employees and consultants and one director. During
          August, 2006, one employee who had been granted 100,000 options left the
          employment of the Company and forfeited them under the terms of the Incentive
          Plan. In November 2006, one employee was granted an additional 100,000
          options.
  F-10
  **O2Diesel
          Corporation**
 **(A
          Development Stage Company)**
 **Notes
          to Consolidated Financial Statements**
 
 Stock
          options generally vest over three years and will expire 10 years from the
          effective date. However, the Company has the latitude under the Incentive
          Plan
          to issue options at various stages of vesting. Once these options are granted
          by
          the Board 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.
  Statement
          of Financial Accounting Standards No. 123 (“SFAS No. 123”) required
          pro forma information regarding net income and earnings per share as if
          the
          Company had accounted for its employee stock options under the fair value
          method
          of SFAS No. 123. 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 for 2006 were an expected life of three
          years,
          a zero dividend yield, volatility ranging from 72% to 209% (depending on
          date of
          grant), and risk free interest rates ranging from 4.64% to 5.09% (depending
          on
          date of grant). The
          assumptions used with this model for 2005 were an expected life of 3 years,
          a zero dividend yield, volatility ranging from 59% to 120% (depending on
          date of
          grant), and risk free interest rates ranging from 3.39% to 3.96% (depending
          on
          date of grant).
 
 For
          purposes of pro forma disclosures, the estimated fair value of the options
          is to
          be amortized over the option’s vesting period. If compensation costs had
          been determined in 2005 based on the fair value at the grant date for awards
          under this plan consistent with the method of SFAS No. 123, the impact
          on the
          Company’s financial results for the year ended December 31, 2005 would have
          been to record additional compensation cost, thereby increasing net loss
          allocable to common stockholders by $767,285 in 2005. This would have increased
          the loss per common share allocable to common stockholders for the year
          ended
          December 31, 2005 by less than $.02 per common share. The following table
          displays the pro forma results of recognizing this compensation
          expense.
 
 **Year
                      Ended December 31,**
                    **2005**Net
                    Loss Allocable to Common Stockholders
                
                $
                (7,471,037
                )Additional
                    Compensation Expense
                
                $
                (767,285
                )Pro
                    Forma Net Loss Allocable to Common Stockholders
                
                $
                (8,238,322
                )Pro
                    Forma Net Loss Per Common Share (basic and diluted)
                
                $
                (0.24
                )
  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). 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
          is
          effective for fiscal years beginning after December 15, 2006. The Company
          is
          currently evaluating what effects the adoption of FIN 48 will have 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.
  F-11
  **O2Diesel
          Corporation**
 **(A
          Development Stage Company)**
 **Notes
          to Consolidated Financial Statements**
 
 Foreign
          Subsidiaries
  The
          Company has foreign subsidiaries whose local currency has been determined
          to be
          the functional currency. For these foreign subsidiaries, the assets and
          liabilities have been translated using the current exchange rates, and
          the
          income and expenses have been translated using the weighted average of
          historical exchange rates during the reporting period. The adjustments
          resulting
          from translation have been recorded separately in shareholders’
(deficit) equity as “other comprehensive income (loss)” and are not
          included in determining the consolidated net loss. As of December 31, 2006,
          other comprehensive income (loss) included ($10,392) of cumulative loss
          from foreign currency translation.
  The
          Company began operations in Brazil in March of 2004 by establishing a 75%
          owned
          subsidiary. The Brazilian subsidiary recognized $0, $0 and $7,682 in revenue
          during the years ended December 31, 2006 and 2005, and the period March,
          2004 (inception) through December 31, 2006, respectively, and had total
          assets
          less current liabilities (exclusive of intercompany amounts eliminated
          in
          consolidation) of $68,245 at December 31, 2006. Transactions in Brazil
          are
          denominated in and the functional currency is the Brazilian Real. At
          December 31, 2006, the Brazilian operations had aggregate losses of
          $1,661,638. 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.
  The
          Company began operations in Spain in April of 2006 by establishing a 100%
          subsidiary. The Spanish subsidiary did not recognize any revenue for the
          year
          ended December 31, 2006 and had total assets less current liabilities (exclusive
          of intercompany amounts eliminated in consolidation) of $56,311 at December
          31,
          2006. Transactions in Spain are denominated in and the functional currency
          is
          the Euro. At December 31, 2006, the Spanish operations had aggregate losses
          of
          $577,377.
  On
          December 31, 2004, the Company ceased operations at two of its wholly-owned
          subsidiaries in the United Kingdom. In connection with the cessation, the
          Company recorded an exchange gain in the 2004 consolidated statement of
          operations of $94,396 to recognize cumulative translation gains previously
          recorded in other comprehensive income (loss). The subsidiaries were
          primarily holding companies and had no assets or liabilities as of
          December 31, 2004. For the years ended December 31, 2006 and December
          31, 2005, these subsidiaries incurred no activity and therefore had no
          profit or
          loss.
 
 Segment
          Reporting
  The
          Company is a development stage company and has not made sales of its products
          in
          commercial volumes. Management believes that the Company currently operates
          and
          manages the business as one business segment.
  Impairment
          of Intellectual Property Rights
  Prior
          to
          the fourth quarter of 2002, the Company was pursuing the marketability
          of a
          technology it had acquired for $424,659. In December 2002, the Company
          determined that the related product was no longer commercially viable and
          would
          no longer be pursued. As a result of this decision, it was determined that
          the
          asset would not be recoverable as there was no alternative market for the
          technology. Accordingly, the net book value of $345,115 was charged to
          general
          and administrative expenses during 2002.
 
 3.
          Government Appropriations
  Appropriation
          from the U.S. Department of Energy (1)
  In
          2002,
          the Company received an appropriation of $1,107,734 from the U.S. Department
          of
          Energy (“DOE”) to test the Company’s fuel additive as well as its blended fuel,
          O2DieselTM. The appropriation was increased to $2,039,650 as of
          September 15, 2004. This appropriation is managed for the DOE by the
          National Renewable Energy Laboratory (“NREL”) under a contract which, as
          amended, continues until June 30, 2007. Under the terms of the contract,
          the Company is reimbursed by NREL for 80% of the costs incurred to complete
          the
          Statement of Work as set forth in the contract. The Company charges all
          expenses
          as incurred to operations and accrues all amounts receivable under the
          contract
          as a reduction to contract expenses when the Company is reasonably certain
          all
          conditions of the reimbursement are satisfied. As of December 31, 2006, the
          Company had incurred cumulative costs of $1,956,445 towards completion
          of the
          contract, leaving a balance of $83,205 in costs to complete the contract.
          From
          the inception of the contract in December 2002 through December 31,
          2006, the Company billed NREL $1,565,156 of which $110,190 is included
          in other
          receivables as of December 31, 2006.
  Appropriation
          from the U.S. Department of Energy (2)
  In
          2003,
          the Company received an appropriation of $1,123,834 to test the Company’s fuel
          additive under the CARB Diesel Emissions Control Strategy
          (DECS) verification rules. The Company is eligible to receive
          reimbursements of 80% of costs incurred under a contract up to the appropriation
          amount, or $899,067. This appropriation is managed for the DOE by NREL,
          the
          National Renewable Energy Laboratory, which contracted with the Company
          in the
          third quarter of 2006. As of December 31, 2006, the Company had incurred
          cumulative costs of $430,972 towards completion of the contract, leaving
          a
          balance of $692,862. From the inception of the contract in August 2006
          through
          December 31, 2006 the Company billed NREL $344,777 of which $344,777 is
          included
          in other receivables as of December 31, 2006.
  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 is currently reviewing several possible test projects and expects
          to
          enter into a contract eligible for approximately 80% reimbursement by the
          second
          or third quarter of 2007.
  F-12
  **O2Diesel
          Corporation**
 **(A
          Development Stage Company)**
 **Notes
          to Consolidated Financial Statements**
 
 Appropriation
          from the U.S. Department of Defense (1):
  In
          2003,
          the Company received an appropriation of $1,000,000 from the U.S. Department
          of
          Defense to test O2DieselTM fuel in non-strategic military vehicles operated by
          the U.S. Air Force at Nellis Air Force Base in Las Vegas, Nevada. Under
          the
          terms of this Appropriation, a third party is to be paid $200,000 to administer
          this program on behalf of the Department of Defense. The remaining $800,000 is
          to be used to fund purchases of O2DieselTM fuel, certain capital equipment and to
          reimburse the Company for its labor, overhead and out-of-pocket costs required
          to complete this project. This contract contains a payment schedule based
          on
          meeting performance milestones. 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 U.S. Department of Defense as is permitted under that
          contract. However, the funds from Appropriation (1) cannot be applied to
          Appropriation (2). Through December 31, 2005, the Company has received cash
          in excess of costs incurred of $296,097 and has recorded Deferred Grants
          at
          December 31, 2005 in the Consolidated Balance Sheet. All amounts billed had
          been received as of December 31, 2005. No additional reimbursements are
          expected from this appropriation. During the fourth quarter of 2006 the
          Company
          was notified from the subcontractor that the contract was officially closed
          and
          O2Diesel has no further requirements. Based on this information, the Company
          applied the previously recorded liability of $296,097 for this contract
          as an
          offset to 2006 grant expenses for the year ended December 31, 2006.
 
 Appropriation
          from the U.S. Department of Defense (2):
  On
          January 11, 2005, the Company entered into a contract with a value of
          $1,085,000 with the U.S. Department of Defense. Under this contract, the
          Company’s O2DieselTM fuel is to be tested in a maximum of forty
          (40) non-tactical vehicles at US Air Force bases in Nevada for an
          18 month period. Furthermore, the Company is to complete certain engine
          testing and other work required for the acceptance of O2DieselTM as a viable
          alternative fuel for use by the Air Force. Work on this contract commenced
          on
          November 1, 2004 and 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 U.S. Department of Defense by a third party contractor.
          The
          Company charges all costs as incurred to expense and accrues all amounts
          receivable under the contract as a reduction to contract expenses. The
          contract
          amount was amended in May 2006 to $1,012,564. 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, 2006, $17,498 remains as
          a
          receivable. No further expenses will be incurred under the contract, which
          is
          expected to be formally closed out in 2007.
 
 Appropriation
          from the U.S. Department of Defense (3):
  The
          Company received an appropriation during 2005 of approximately $910,000
          from the
          Department of Defense. Concurrent Technologies Corporation (CTC) manages
          this appropriation on behalf of the Department of Defense. This contract
          contains a payment schedule based on meeting performance milestones. 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. The other bases will be selected during 2007 and field
          demonstrations will commence by the end of the year. As of December 31,
          2006,
          $520,041 in expenses has been incurred, leaving an available balance of
          $389,959. Of the $530,000 invoiced, $75,000 remains as a receivable at
          December
          31, 2006. In addition the Company has issued billings in excess of costs
          of
          $9,959 and has recorded Deferred Grants at December 31, 2006 in the Consolidated
          Balance Sheet.
 
 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 O2DieselTM. The Company expects to enter into a
          contract for this work during the first quarter of 2007. The Company can
          receive
          reimbursement from this appropriation of up to the entire
          $1,100,000.
  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 O2 Diesel. The company expects to enter into
          a
          contract for this work during the second quarter of 2007. The company can
          receive reimbursement from this appropriation of up to the entire
          $1,000,000.
  F-13
  **O2Diesel
          Corporation**
 **(A
          Development Stage Company)**
 **Notes
          to Consolidated Financial Statements**
 
 4.
          Other
          Receivables
  Other
          Receivables consisted of the following at December 31, 2006
  ITC
                      Appropriation
                  
                  $
                  17,498NREL
                      Appropriation
                  
                  
                  454,967CTC
                      Appropriation
                  
                  
                  75,000EPIC
                      & Prime Bio (City Home Sponsorship)
                  
                  
                  9,000Due
                      from ProEco
                  
                  
                  150,000Reimbursement
                      of expenses and services performed
                  
                  
                  26,122$
                  732,587
 5.
          Accrued Liabilities
  Accrued
          liabilities consisted of the following at December 31, 2006
  Legal
                      and professional
                  
                  $
                  126,208Investor
                      Relations
                  
                  
                  120,000Other
                  
                  
                  140,459$
                  386,667
  *
          Note;
          Within Investor Relations, the Company recorded an accrual for an investor
          relations outsourcing contract ($120,000).
 
 6.
          Deferred Financing and Business Acquisition Costs
  During
          2003, management began the process to list its common stock on the Alternative
          Investment Market (AIM) in London, England. All legal, accounting, and
          other related costs incurred in connection with the AIM listing were capitalized
          as deferred financing costs. In December 2003, management determined that
          the Company would terminate its plan to seek an AIM listing. Accordingly,
          deferred financing costs of $517,000, were charged to expense for the year
          ended
          December 31, 2003.
  The
          Company records the cost of equity financings as a reduction of the associated
          proceeds.
 
 7.
          Income
          Taxes
  No
          provision for Federal and state income taxes has been recorded during the
          periods presented due to the Company’s significant operating losses in each
          year. The income tax benefit reflected in the accompanying consolidated
          statement of operations is the benefit recognized in Ireland for the periods
          presented.
  Deferred
          income taxes reflect the net tax effects of temporary differences between
          the
          carrying amounts of assets and liabilities for financial reporting purposes
          and
          the amounts used for income tax reporting purposes. Significant components
          of
          the Company’s deferred tax asset as of December 31, 2006 are as
          follows:
  Net
                    operating loss carryforwards
                
                $
                9,008,250Deferred
                    revenue
                
                
                397,000Accrued
                    expenses
                
                
                148,000Total
                    deferred tax assets
                
                
                9,553,250Valuation
                    allowance
                
                
                (9,553,250
                )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 December 31, 2006, the Company had Federal
          and state net operating loss carryforwards of approximately $21.5 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 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 December 31, 2006,
          the Company had an Irish net operating loss carryforward of approximately
          $640,000 which can be carried forward indefinitely, cumulative Spanish
          losses of
          approximately $575,000 and a Brazilian net operating loss of approximately
          $1,425,000 that may be carried forward indefinitely, but which is subject
          to
          annual usage limitations.
  F-14
  **O2Diesel
          Corporation**
 **(A
          Development Stage Company)**
 **Notes
          to Consolidated Financial Statements**
 
 8.
          Stockholders’ Equity
  Recapitalization
  On
          July 15, 2003, O2Diesel Corporation and AAE Technologies International Plc
          (AAE) entered into a merger transaction whereby O2Diesel acquired all of
          the issued and outstanding share capital of AAE in exchange for the issuance
          of
          17,847,039 shares of common stock of O2Diesel. Although O2Diesel was the
          legal
          acquirer, AAE was deemed to be the accounting acquirer. The transaction
          was
          accounted for as an AAE capital transaction, accompanied by a
          recapitalization.
  As
          a
          result of the transaction, the historical financial statements of AAE are
          deemed
          to be those of the Company for financial reporting purposes. The equity
          accounts
          of AAE have been adjusted for the recapitalization to reflect the equity
          structure of O2Diesel, the legal acquirer. Specifically, the historical
          stockholders’ equity of AAE prior to the transaction has been affected for the
          equivalent number of shares of O2Diesel common stock received in the
          transaction, with an offset to paid-in capital; the accumulated deficit
          of AAE
          was carried forward after the transaction; and the loss per share for all
          periods prior to the transaction was restated to reflect the number of
          equivalent common shares received by AAE in the transaction.
 
 Issuances
          of Common Stock
  In
          connection with the merger between O2Diesel and AAE in July 2003, the
          Company completed a private placement of 3,333,333 shares of common stock
          at
          $1.50 per share. The private placement was partially effectuated through
          the
          issuance of a $4 million convertible note that was convertible into the
          Company’s common stock at $1.50 per share. In October 2003, the Company
          repaid $1,677,500 of the note and the $2,322,500 balance was converted
          into
          1,548,333 shares of common stock. The remaining 1,785,000 shares of common
          stock
          issuable under the private placement were issued to other parties in exchange
          for cash proceeds of $2,677,500. The expenses associated with the merger
          and
          subsequent issuances of shares were $795,650 and have been reflected as
          a
          reduction of paid-in capital.
 
 During
          the second 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 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 additional shares of common stock pursuant to the follow-on private
          placement. The Company received $386,325 in gross proceeds related to the
          subscriptions for the 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 advances 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
          as of
          June 30, 2004. In total, the Company received $1,535,877 and issued
          1,025,784 shares of common stock pursuant to the follow-on private
          placement.
 
 **$2.0
          and $3.0 Million Private Placements**
  In
          January 2005, the Company retained a third party to raise, in a series of
          two private placements of the Company’s common stock, $5.0 million at a
          price of $0.70 per share. This offering price per share represented a discount
          from the market value of our common stock of approximately ten-percent
          (10%).
          The first private placement was for just under $2.0 million
          (“$2.0 million Private Placement”) and the second private placement was for
          just over $3.0 million (“$3.0 million Private Placement”, and together
          with the $2.0 million Private Placement, the “Private Placements”). As part
          of this transaction, the Company was obligated to comply with certain conditions
          in connection with the $2.0 million Private Placement and was also
          obligated to satisfy still other conditions applicable to the $3.0 million
          Private Placement. Further, the AMEX requires that shareholder approval
          be
          obtained by the Company for the sale of common stock in a transaction if
          the
          price of the shares to be sold is less than the greater of book or market
          value,
          and the number of shares equal 20% or more of the presently outstanding
          common
          stock. In order to comply with this requirement, the Company was required
          to
          seek shareholder approval for the $3.0 million Private Placement. No
          shareholder approval was required for the shares issued in conjunction
          with the
          $2.0 million Private Placement.
  Pursuant
          to the $2.0 million Private Placement, the Company received qualified
          subscriptions for 2,803,428 shares of its common stock and total proceeds
          of
          $1,962,400 before payment of an 8% commission and other expenses. The parties
          subscribing to these shares agreed to waive certain of the conditions to
          permit
          the transaction to be closed as to their respective subscriptions. An initial
          closing for the $2.0 million Private Placement was held on March 17,
          2005 for 1,915,143 shares. A final closing for the remaining 888,285 shares
          was
          held on May 20, 2005.
  On
          June 10, 2005, an initial closing was held for the $3.0 million
          Private Placement covering 4,583,973 shares of common stock, for total
          proceeds
          of $3,208,781, before payment of an 8% commission and other expenses. In
          addition, the Company received additional subscriptions for 128,580 shares
          of
          its common stock and cash of $90,006, before payment of an 8% commission.
          As
          part of the terms for the $3.0 million Private Placement, the Company was
          required to satisfy two conditions in order to close the transaction. As
          indicated above, the first condition required that shareholder approval
          be
          obtained to issue the shares, and this was approved by the Company’s
          shareholders at its annual shareholder meeting held on May 31, 2005.
          Pursuant to the second condition, the Company was required to expand its
          senior
          management team, and it did so by creating the position of Chief Operating
          Officer and President. The Board
          of
          Directors (the “Board”) confirmed that both of these conditions had been
          satisfied as of May 31, 2005. On August 9, 2005, the Company received the
          final $89,874 (after expense) for the $3.0 million Private Placement, and
          these transactions are now closed.
  F-15
  **O2Diesel
          Corporation**
 **(A
          Development Stage Company)**
 **Notes
          to Consolidated Financial Statements**
  In
          total,
          the Company received $4,833,192 (after expenses) from the $2.0 million and
          $3.0 million Private Placements and it issued 7,535,981 shares of its
          common stock.
  Subscribers
          to both of the Private Placements received one warrant to purchase one
          additional share of common stock for each two shares of common stock purchased.
          The warrant expires twenty-four months following the closing of the
          $2.0 million Private Placement and the $3.0 million Private Placement,
          respectively. Each warrant is exercisable at a price of $0.70 per share
          during
          the first twelve months following the close of each Private Placement,
          or at an
          exercise price of $1.05 per share in the second twelve months following
          the
          close of each Private Placement. The total number of warrants issued was
          3,757,990.
 
 **$2.3
          Million Private Placement**
  On
          September 20, 2005, the Company entered into a Common Stock and Warrant
          Purchase Agreement (“$2.3 million Purchase Agreement”) with a European
          investor (the “Purchaser”) for 3,228,070 shares of common stock at a purchase
          price of $0.7125 per share in a private placement for total proceeds of
          $2,300,000 (the “$2.3 million Private Placement”). As a condition of
          enforceability of the Purchase Agreement against the Company, the Purchaser
          was
          required to fund the purchase price in an escrow account, which funds were
          received on September 28, 2005.
  As
          part
          of this sale, the Company also issued warrants to purchase 1,614,035 shares
          of
          common stock at an exercise price of $1.425 per share during the period
          of six
          months to forty-two months subsequent to issuance or at a cashless exercise
          if a
          registration statement is not effective within one year of issuance. The
          warrants expire forty-two months after the date of issuance.
  As
          part
          of the transaction, the Company agreed to sell up to an additional $700,000
          of
          its common stock with detachable warrants to the Purchaser at a purchase
          price
          of $0.7125 per share, or 982,456 shares. This offer expired unexercised
          on March
          20, 2006.
  The
          Company agreed to issue warrants to purchase 1,614,035 shares of common
          stock at
          an exercise price of $0.7125 per share to its advisor in connection with
          this
          transaction. The warrants expire forty-two months after the date of
          issuance.
  The
          transaction closed and the warrants were issued on October 24, 2005 and the
          funds were released from the escrow account on October 26, 2005. In
          addition, in connection with this transaction, the Company entered into
          an
          investor relations contract that awarded 100,000 shares of restricted common
          stock which vests over a one year period ended September 20, 2006. As of
          December 31, 2006, the restrictions on all 100,000 shares issuable under
          this
          contract have lapsed and such shares were earned and able to be sold.
 
 **$3.6
          Million Private Placement**
  On
          October 28, 2005, the Company entered into an agreement with a European
          producer of bioethanol to provide funding and commercial support to develop
          the
          European market for the Company’s products. The parties entered into a Common
          Stock and Warrant Purchase Agreement for 6,419,840 shares of the Company’s
          common stock in a private placement, for total proceeds of 3,000,000€, or
          approximately $3.6 million at the then current exchange rates. The Company
          agreed to use these funds exclusively for the development of the European
          market. The parties also entered into a Commercial Agreement, in which
          the
          investor and the Company will jointly develop the market for the Company’s
          products in Europe during a five year period. As part of the Commercial
          Agreement, the investor will be the exclusive supplier of the ethanol to
          be used
          in the blending of the Company’s product within the territory.
  As
          part
          of the transaction, the Company issued warrants to purchase 2,853,262 shares
          of
          common stock at an exercise price of $0.85 per share during the period
          six to
          forty two months subsequent to the date of issuance or at an exercise price
          of
          $1.13 per share during the period forty three to sixty six months after
          the date
          of issuance. The warrants expire sixty six months after the date of
          issuance.
  The
          transaction closed and the funds were received on December 16,
          2005.
 
 **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.
  F-16
  **O2Diesel
          Corporation**
 **(A
          Development Stage Company)**
 **Notes
          to Consolidated Financial Statements**
 
 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.
  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
          accretes
          the value of the beneficial conversion feature through equity and records
          a
          deemed dividend to preferred stockholders. The Company recorded a deemed
          dividend to preferred shareholders of $5,581,133, $618,872 and $6,200,005
          in the
          consolidated statements of operations for the years ending December 31,
          2006,
          December 31, 2005 and the period October 14, 2000 (inception) through December
          31, 2006, respectively. The amount recorded for the year ended December
          31, 2006
          reflected that 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.
 
 **** **$4.0
          and $2.5 Million Private Placements** ****
  On
          April
          6, 2006, the Company entered into a Common Stock and Warrant Purchase Agreement
          (“$4.0 million Purchase Agreement”) with a UK investor (the “Investor”) for
          5,333,333 shares of common stock at a purchase price of $0.75 per share
          in a
          private placement for total proceeds of $4,000,000 (the “$4.0 million Private
          Placement”). As part of this sale, the Company also issued warrants to purchase
          2,666,667 shares of common stock at an exercise price of $0.825 per share
          during
          the period of six months to forty-two months subsequent to issuance. The
          warrants expire forty-two months after the date of issuance. The Investor's
          obligation to purchase the shares was subject to the Company satisfying
          certain
          additional conditions.
  Also
          on
          April 6, 2006, the Company entered into a Common Stock and Warrant Purchase
          Agreement (“$2.5 million Purchase Agreement”) with a different European
          investor (the “2 nd Investor”) for 3,333,333 shares of common stock at a purchase price of $0.75 per
          share in a private placement for total proceeds of $2,500,000 (the “$2.5 million
          Private Placement”) before payment of a 9% commission and other expenses. As
          part of this sale, the Company also issued warrants to purchase 1,666,667
          shares
          of common stock at an exercise price of $0.825 per share during the period
          of
          six months to forty-two months subsequent to issuance. The warrants expire
          forty-two months after the date of issuance. The 2 nd Investor's obligation to purchase the shares was subject to the Company
          satisfying certain additional conditions.
  F-17
 
 **O2Diesel
          Corporation**
 **(A
          Development Stage Company)**
 **Notes
          to Consolidated Financial Statements**
 
 The
          purchase price of both transactions represented a discount of approximately
          10%
          in comparison to the prevailing market price of the Company's common stock
          during the period of negotiations for these private placements.
  Subsequent
          to entering into these agreements, the Company entered into an identical
          amendment to each agreement which (i) modified the amount of liquidated
          damages
          to a maximum of 8% of the purchase price and (ii) added that shareholder
          approval will be obtained prior to the Company issuing the shares of common
          stock issuable upon exercise of the warrants. There were no other changes
          to
          either agreement. Both transactions closed on April 27, 2006.
  AMEX
          requires that shareholder approval be obtained by the Company for the sale
          of
          common stock in a transaction if the price of the shares to be sold is
          less than
          the greater of book or market value, and the number of shares equal
          twenty-percent (20%) or more of the presently outstanding common stock.
          In order
          to comply with this requirement, the Company was required to obtain shareholder
          approval for the $4.0 and the $2.5 million Private Placements. Shareholder
          approval was obtained at the Company's annual shareholder meeting on July
          6,
          2006.
 
 **$1.0
          Million Private Placement**
  On
          September 15, 2006, the Company entered into an agreement with an Asian
          supplier
          of alternative fuels and its wholly owned subsidiary to provide funding
          and
          commercial support to develop a market in certain countries in South Asia
          and
          Asia Pacific for the Company's products.
  The
          parties entered into a Common Stock and Warrant Purchase Agreement ("$1.0
          million Purchase Agreement") for 1,371,742 shares of the Company's common
          stock
          at a purchase price of $0.729 per share in a private placement for total
          proceeds of $1,000,000. As a condition of enforceability of the Agreement
          against the Company, the Asian supplier was required to fund the purchase
          price
          in an escrow account, which funds were received and deposited into escrow
          on
          October 19, 2006.
  As
          part
          of the sale, the Company issued warrants to purchase 685,871 shares of
          common
          stock at an exercise price of $0.972 per share during the period of six
          months
          to sixty-six months subsequent to issuance. The warrants expire
          sixty-six months after the date of issuance. The Asian supplier's obligation
          to
          purchase the shares is subject to the Company satisfying certain additional
          conditions.
  The
          parties also entered into a Supply and Distribution Agreement (the “Supply
          Agreement”), in which the parties will jointly develop the market for O2DieselTM
in South Asia and Asia Pacific during a five year period. As part of the
          Supply
          Agreement, the Asian supplier will be the exclusive distributor of O2DieselTM
within the territory.
  As
          part
          of the transaction, upon certain purchases of O2DieselTM, the Company has agreed
          to sell up to an additional $250,000 of its common stock to the Asian supplier
          at a purchase price of $0.729 per share for 342,936 shares and to issue
          warrants
          to purchase up to 685,871 shares of common stock at an exercise price of
          $1.1664
          per share. These warrants expire sixty-six months after the date of
          issuance.
  The
          purchase price of this transaction represented a discount of approximately
          25%
          in comparison to the prevailing market price of the Company's common stock
          during the period of negotiations for this private placement.
  On
          November 9, 2006, the Company entered into Amendment No. 1 to the
          $1.0 million Purchase Agreement with the Asian supplier. The amendment
          corrected the minimum purchase amount of additive for the purchase of additional
          shares by the Asian supplier. There were no other changes to the
          $1.0 million Purchase Agreement.
  The
          common stock and the warrants were issued to the accredited investor in
          a
          transaction that is exempt from registration pursuant to Section 4(2) of
          the
          Securities Act of 1933, as amended (the “Securities Act”), and/or Regulation D
          promulgated under the Securities Act.
  The
          transaction closed and the funds were received on November 22,
          2006.
 
 **** Options/Restricted
          Shares
 
 The
          Company implemented a Stock Incentive Plan (the “Incentive Plan”) in 2004 for
          which the Board of Directors has authorized 7,212,957 shares of common
          stock to
          be reserved for future issuance under the Plan. At December 31, 2005, the
          Company had committed to award 7,750,000 options to purchase common stock
          to
          certain officers, employees and directors, of which 5,950,000 options had
          been
          approved and granted by the Board of Directors. As of June 30, 2006, one
          employee who had been promised (but not granted) 600,000 options left the
          employment of the Company and forfeited the promised options. Four other
          employees received new promises for 350,000 options, resulting in net
          commitments from the Company of 7,500,000 options to purchase common stock.
          The
          Company obtained approval from the shareholders at the annual meeting on
          July 6,
          2006 to increase the number of common shares available for issuance under
          the
          Incentive Plan to 9,750,000 in order to effectuate the grant of the remaining
          stock options promised to plan participants. Subsequent to this approval,
          the
          Board of Directors granted the promised 350,000 options and an additional
          1,200,000 options to six other employees and consultants and one
          director. During August 2006, one employee who had been granted 100,000
          options left the employment of the Company and forfeited them under the
          terms of
          the Incentive Plan. In November, 2006, one employee was granted an additional
          100,000 options.
  F-18
 
 **O2Diesel
          Corporation**
 **(A
          Development Stage Company)**
 **Notes
          to Consolidated Financial Statements**
 
 As
          of
          December 31, 2006, the Company had granted options to the following
          groups:
  Directors
                
                
                3,000,000Officers
                
                
                3,150,000Employees
                    & Consultants
                
                
                1,350,000Total
                
                
                7,500,000
  The
            weighted average fair values of the options granted were $1.15, $0.21
            and $0.42
            during the years ended December 31, 2006 and 2005, and for the period
            October
            14, 2000 (inception) through December 31, 2006, respectively. The expense
            related to the fair value of stock options issued during the year ended
            December
            31, 2006 was $1,476,684. The total value of shares vested during the years
            ended December 31, 2006, 2005 and for the period October 14, 2000 (inception)
            through December 31, 2006 was $1,544,467, $727,530 and $2,271,997, respectively.
            As of December 31, 2006, the compensation cost related to non-vested awards
            amounted to $424,255 and is expected to be recognized over a weighted
            average
            period of 1.43 years.
 The
          following table shows the outstanding options granted under the 2004 Stock
          Incentive plan
 
 **Weighted
                    Ave****Weighted
                    Ave**
                
                **Remaining****Shares**
                
                **Exercise
                    Price**
                
                **Contractual
                    Term**Outstanding
                    at January 1, 2005
                
                
                500,000
                
                $
                1.50Granted
                    in 2005
                
                
                5,450,000
                
                $
                1.50
                
                
                8.7Exercised
                    in 2005Forfeited
                    or ExpiredOutstanding
                    at December 31, 2005
                
                
                5,950,000
                
                $
                1.50
                
                
                8.7Granted
                    During the Year Ended December 31, 2006
                
                
                1,350,000
                
                $
                1.28
                
                
                9.5200,000
                
                $
                1.50
                
                
                9.5100,000
                
                $
                0.71
                
                
                9.9Exercised
                    During the Year Ended December 31, 2006Forfeited
                    or Expired
                
                
                (100,000
                )
                $
                1.28Outstanding
                    at December 31, 2006
                
                
                7,500,000
                
                $
                1.45
                
                
                8.8Exercisable
                    at December 31, 2006
                
                
                5,583,000
                
                $
                1.47
                
                
                8.8
 
 Restricted
          Stock Awards
 
 On
          September 20, 2005, the Company entered into an investor relations
          consulting agreement for a term of one year. In exchange for services,
          the
          Company will pay the consultant $7,250 per month. In addition, the Company
          awarded the consultant 100,000 shares of restricted stock. For the years
          ended
          December 31, 2006, and 2005, and for the period October 14, 2000 (inception)
          through December 31, 2006, the Company recognized $51,000, $30,500 and
          $81,500,
          respectively, in connection with the stock award. As of December 31, 2006,
          the
          restrictions on all 100,000 shares issued under this contract have lapsed
          and
          such shares were earned and able to be sold.
 
 Warrants
  A
          wholly-owned subsidiary of the Company entered into a supply and distribution
          agreement (the “Distribution Agreement”) with a distributor dated December 10,
          2004 that granted to the distributor a warrant to purchase 600,000 shares
          of
          O2Diesel’s common stock at a price of $2.00 per share. The warrant expires on
          May 5, 2007.
 
 On
          February 3, 2006, the Company offered existing warrant holders from the
          $2.0 million and $3.0 million Private Placements and the $2.3 million
          Private Placement an opportunity to exercise their warrants at the reduced
          price
          of $0.35 per share. On February 27, 2006, the Warrant Offering expired and
          the Company received proceeds of $592,692 (after expenses) for the exercise
          of
          warrants to purchase 1,864,035 shares of common stock. Between May 31-June
          12,
          2006, several other existing warrant holders elected to exercise their
          warrants
          at the contract price identified in their warrant documentation. Proceeds
          for
          these exercises were $865,452 (after expenses) for the purchase of 1,287,857
          shares of common stock.
  F-19
 
 **O2Diesel
          Corporation**
 **(A
          Development Stage Company)**
 **Notes
          to Consolidated Financial Statements**
  The
          following schedule presents shares of common stock issued and outstanding
          and
          reserved for future issuance as of December 31, 2006:
 
 Common
                    Shares Outstanding
                
                
                
                
                
                75,125,014Reserved
                    For Future IssuanceOptions
                    Granted to officers and directors
                
                
                7,500,000Restricted
                    Stock Award to Officer
                
                
                500,000Warrants
                
                
                12,306,636
                
                
                20,306,636Total
                    shares issued and outstanding and reserved for future issuance
                    at December
                    31, 2006
                
                95,431,650
 
 9.
          Related Party Transactions
  A
          company
          controlled by a former Chairman of the Board provides office space, accounting
          and other services to the Company at a cost of approximately $2,500 per
          month to
          the Company’s Irish subsidiary. For the years ending December 31, 2006, and
          2005, and for the period October 14, 2000, (inception) through
          December 31, 2006, the Company paid $17,956, $28,597, and $179,851,
          respectively to the company controlled by the former Chairman. At
          December 31, 2006, $7,500 was accrued as a payable to this related
          party.
  Included
          in receivables due from related parties at December, 31, 2006 is $36,040
          which
          is related to travel advances made to employees.
  The
          Company has entered into two separate consulting contracts with two shareholders
          of its Brazilian subsidiary for the purpose of providing office rent and
          administrative services and in lieu of employment contracts with these
          two
          individuals. These two contracts provide support significant to the operation
          of
          the Brazilian subsidiary. For the years ended December, 31, 2006, and 2005,
          and
          for the period October 14, 2000, (inception) through December 31, 2006,
          the
          Company incurred expenses of $182,008, $204,483, and $473,392, respectively,
          with these related parties.
 
 10.
          Commitments
  Operating
          leases
  The
          Company leases certain office equipment under agreements that are accounted
          for
          as operating leases. As of December 31, 2006, future minimum lease payments
          under non-cancelable operating leases were as follows:
  **Operating
          Leases**
  **2007**
                
                **$**
                **101.463****2008**
                
                
                **89,779****Total**
                
                **$**
                **191,242**
  Rent
          expense under the leases with unrelated parties for the years ended
          December 31, 2006, and 2005, and the period October 14, 2000,
          (inception) through December 31, 2006, were $124,300, $91,642 and
          $296,475 respectively.
  Truck
          Loan
  On
          November 4, 2004, the Company purchased a diesel truck to be used for
          product testing and analysis. The cost of this vehicle was $26,545. Subsequent
          to this purchase the Company financed $23,000 of the purchase price with
          a bank.
          The loan was secured by the truck. The note bears interest at 7.00 % and
          was
          payable in 24 monthly installments of $1,031 with the final payment due in
          November of 2006. The Company disposed of the truck in November, 2005 and
          received proceeds of $11,900 which were used to pay off the balance of
          the
          loan.
 
 11.
          Subsequent Events
 
 **ProEco
          Transaction**
 
 On
          January 12, 2007, the Company entered into a share exchange agreement (the
          “Agreement”) with ProEco Energy Company (“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.
  F-20
 
 **O2Diesel
          Corporation**
 **(A
          Development Stage Company)**
 **Notes
          to Consolidated Financial Statements**
 
 ProEco,
          which has had limited operations to date, is in the process of developing a
          new fuel-grade ethanol plant (the “Ethanol Plant”) with planned capacity of 100
          million gallons per year to be built in two 50 million gallon trains (each
          a
“Train ”). ProEco Shareholders will receive 60% of the Transaction Shares at the
          time of the closing and will receive the remaining 40% of the Transaction
          Shares
          in two equal installments upon the completion of construction of the first
          Train
          (20%) and the commencement of construction of the final Train (20%). The
          remaining 40% of the Transaction Shares will be held in escrow until the
          conditions for their release have been met. The parties intend the transaction
          to qualify as a tax-free reorganization under Section 368(a) of the U.S.
          Internal Revenue Code of 1986, as amended.
 
 The
          share
          exchange agreement requires ProEco to complete a number of steps toward
          completion of the Ethanol Plant project in order for the closing of the
          share
          exchange to occur. At the time of the closing, ProEco must have entered
          into a
          definitive engineering, procurement and construction contract with a reputable
          firm with extensive experience in implementing and completing projects
          similar
          to the Ethanol Plant project and executed marketing agreements for the
          sale of
          the production of the Ethanol Plant. Under the terms of the share exchange
          agreement, ProEco is responsible for having the Ethanol Plant designated
          as a
          facility nameplated, or certified, as producing ethanol at a level of at
          least
          100 million gallons of production a year.
 
 As
          a
          condition to the closing of the ProEco share exchange, the Company is obligated
          to secure the financing necessary to complete the construction costs to
          build
          the Ethanol Plant. Accordingly, the Company will be required to
          raise $120 to $140 million in debt and between $60 to $80 million in equity
          in two tranches in 2007.
 
 Prior
          to
          closing, the Company and the ProEco Shareholders will enter into a stockholder
          agreement that will, among other things, impose restrictions on the transfer
          of
          the Transaction Shares.
 
 The
          Common Stock will be issued to the ProEco Shareholders in a transaction
          that
          will be exempt from the registration requirement pursuant to Section 4(2)
          of the Securities Act and under Regulation D promulgated under the
          Securities Act.
 
 **Fusion
          Transaction**
 
 On
          February 16, 2007, the Company entered into a common stock purchase agreement
          (the “Purchase Agreement”) with Fusion Capital Fund II, LLC, an Illinois limited
          liability company (“Fusion Capital”). Pursuant to the Purchase Agreement, at the
          Company's discretion, the Company may sell up to $10 million of the Company's
          common stock to Fusion Capital from time to time over a 25-month period.
          The
          Company has reserved for issuance up to 12,000,000 shares of the Company's
          common stock for sale to Fusion Capital under this agreement. Subject to
          earlier
          termination at the Company's discretion, Fusion Capital's purchases will
          occur
          after the SEC has declared effective the registration statement related
          to the
          transaction. The Company has agreed to issue to Fusion Capital 805,987
          shares of
          the Company's common stock as a commitment fee for entering into the Purchase
          Agreement.
 
 Concurrently
          with entering into the Purchase Agreement, the Company entered into a
          registration rights agreement with Fusion Capital (the “Registration Rights
          Agreement”). Under the Registration Rights Agreement, the Company agreed to file
          a registration statement with the SEC covering the shares that have been
          issued
          or may be issued to Fusion Capital under the Purchase Agreement. After
          the SEC
          has declared effective the registration statement, generally the Company
          has the
          right but not the obligation from time to time to sell shares of the Company's
          common stock to Fusion Capital in amounts between $100,000 and $1 million
          depending on certain conditions. The Company has the right to control the
          timing
          and amount of any sales of the Company's shares to Fusion Capital. The
          purchase
          price of the shares will be determined based upon the market price of the
          shares
          of common stock without any fixed discount. Fusion Capital shall not have the
          right or the obligation to purchase any shares of the Company's common
          stock on
          any business day that the price of the Company's common stock is below
          either
          $0.50 or $0.60, depending on the transaction size of the purchase. The
          agreement
          may be terminated by the Company at any time at its discretion without
          any cost
          to the Company.
 F-21