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corresp

October 4, 2005

BY EDGAR

Mr. George F. Ohsiek, Jr.

Securities and Exchange Commission

100 F Street, N.E.

Washington, D.C. 20549

    Re:

    O2Diesel Corporation

    Form 10-KSB for Fiscal Year Ended December 31, 2004

    Filed March 31, 2005

    Form 10-QSB for Fiscal Quarter Ended March 31 and June 30, 2005

    File No. 1-32228

Dear Mr. Osheik,

     I
am writing in response to your letter dated September 13, 2005 concerning O2Diesel
Corporation’s (the “Company” or “O2Diesel”) Form 10-KSB for fiscal year ended December 31, 2004
(“Form 10-K”) and Form 10-QSB for fiscal quarters ended March 31 and June 30, 2005 (“Form 10-QSB,”
and together with Form 10-KSB, the “Previous Filings”). For your convenience, the numbered
responses below correspond to the numbered comments in your letter.

    1.

    “We have read your response to prior comment 2 and
note your intention to revise the disclosure to state that
“there have not been any significant changes...” Please
note that Item 308(c) of Regulation S-B requires you to
disclose any changes, not just significant changes, in your internal
controls over financial reporting that have materially affected, or
are reasonably likely to materially affect, your internal controls
over financial reporting. Please revise your filings
accordingly.”

    We propose to revise this disclosure in our Previous Filings as follows:

    “EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES. O2Diesel’s Chief Executive Officer and
Chief Financial Officer have evaluated the effectiveness of O2Diesel’s disclosure controls
and procedures (as such term is defined in Rules 13a-15 and 15d-15 under the Securities
Exchange Act of 1934, as amended) as of the end of the period covered by this report (the
“Evaluation Date”). Based on such evaluation, such officers have concluded that, as of the
Evaluation Date, O2Diesel’s disclosure controls and procedures are effective.

    CHANGES IN INTERNAL CONTROLS OVER FINANCIAL REPORTING. During the most recent fiscal
quarter, there have not been any changes in the Company’s internal controls over financial
reporting or in other factors that have materially affected, or are reasonably likely to
materially affect internal controls over financial reporting.”

    2.

    “We have read your response to prior comment 3. You
indicate that subsequent to the delivery of the goods and transfer of
title to the customer, the work necessary to prepare certain military
vehicles was delayed due to the inability to source flame arrestors.
Please clarify whether or not it was your obligation, in connection
with the sale, to perform this additional work. If the additional
steps necessary to prepare the vehicles for the use of O2Diesel were
your responsibility, tell us how you determined that revenue
recognition was appropriate upon transfer of title. Please also
clarify whether customer acceptance was contingent on the customer
obtaining the necessary environmental permit and what impact, if any,
such terms had on revenue recognition.

    In order to provide a framework behind our response to the Staff’s comment, we thought
it was important to provide you with a summary background regarding the distribution of our
product. O2Diesel’s core product is an additive that is blended with regular diesel fuel
and ethanol to create an alternative fuel blend called
O2Diesel™. 02Diesel does not sell
the additive directly to the end user because such entities generally do not have the
facilities required to blend the additive with the diesel fuel and ethanol in order to
create the alternative fuel blend. Instead, O2Diesel relies on value added distributors
commonly referred to as “jobbers” to create the alternative fuel blend and distribute it to
the end users. Although O2Diesel sometimes enters into joint marketing arrangements with
the jobbers, the Company’s sale of the additive to the jobbers is final at the time of

    the delivery of the additive to the jobber. Such sale is not dependent upon the jobber’s
successful completion of the alternative fuel blend and its ultimate sale to the end user.
Accordingly, the Company records the sale of the additive to the jobber at the time the
additive is delivered to the jobber as long as the four basic criteria for revenue
recognition are met.

    With regard to the $14,000 sale that is the subject of the Staff’s comment, the Company
concluded that the four basic criteria for revenue recognition were met at the time the
additive was delivered to the jobber. This conclusion was based upon the known attributes
of the existing sales arrangement with the jobber and the Company’s past history of
successful sales to this same jobber. Subsequent to the completion of the sale of the
additive to the jobber, the jobber encountered unforeseen complications with regard to their
sale of the alternative fuel blend to the end user. These complications included the
necessity of obtaining a permit from a local government agency to store and use the
alternative fuel blend on the military base and the required adjustments to the devices
(called flame arrestors) used to modify the vehicles to equip them to use the alternative
fuel blend. Although O2Diesel was responsible for the resolution of these issues,
the sales arrangement between the Company and the jobber did not include provisions for
nonpayment for the additive should the jobber be unsuccessful in selling through to the end
user. Further, the O2Diesel employees responsible for the customer relationship with the
military base believed that the work on the base’s fueling facilities and on the
vehicles was substantially complete and that fueling of these vehicles could commence
following the sale of the additive to the jobber. These employees based their conclusion on
the Company’s history of successful deployments at other facilities.

    Given the ensuing complications and the uncertainty of their resolution, the jobber was
unable to sell the completed fuel to the military and objected to paying for the additive.
As a consequence, a business decision was made to not enforce payment from the jobber. This
decision was a concession and was not an enforceable right in the arrangement between
O2Diesel and the jobber. The receivable from this jobber was reserved for and an
accompanying charge to expense was taken when collection of the receivable became in doubt.
The fact that the four basic
criteria for revenue recognition were met at the time of the sale of the additive to the
jobber, we concluded that it was appropriate to record the charge related to the write-down
of the receivable in the period in which its collection became in doubt. Although $14,000 is material
to total revenue reported, we believe that the total revenue and the $14,000 are
immaterial to the net loss.

    3.

    “We have read your response to prior comment 5. Please provide us with example
journal entries for the entire CityHome program transaction flow so that we may
better understand the narrative explanation your provided.”

    Through the City/Home program, we sold our additive to the City of Lincoln Nebraska’s
StarTran/Public Works & Utilities Department (“StarTran”) through a jobber at a loss in
exchange for the right to use the advertising space available on nine StarTran buses. We
recorded the sale of the additive to jobber and the related loss at the time of the sale
because the four basic criteria for revenue recognition related to that product sale were
met. No value was assigned to the advertising space received from StarTran at that time, because we
were uncertain as to whether or not we would be able to sell the advertising space to a third party.
We then sold the advertising space to a third party (in this case E-10 Unleaded Coalition)
for $15,000 and incurred the cost of providing the advertising. We deferred the $15,000
payment received for the advertising space and are amortizing it to revenue ratably over
the period in which the advertising is required to be displayed on the bus. We expensed
the cost of preparing and installing the advertising immediately. Outlined below are
sample entries associated with these transactions.

(1)

    Accounts Receivable

    XX

    Expense

    YY

    Sales

    XX

    Accrued Expenses

    YY

    Inventory

    YY

To record sale of the additive to the jobber at a loss

(2)

    Cash

    XX

    Deferred
Revenue

    XX

To
record the payment received from the
3rd
party for providing advertising space

(3)

    Expense

    XX

    Accrued Expenses

    XX

To record expenses associated with the direct cost of preparing the advertising and installing it
on the bus

(4)

    Deferred Revenue

    XX

    Revenue

    XX

To record amortization of the deferred revenue ratably over the period in which the advertising is
required to be displayed on the bus.

    4.

    “We have read your response to prior comment 9. Please revise your
certifications to eliminate “as Chief Executive Officer” and “as
Chief Financial Officer” from the first sentence of the certification.”

    We propose to revise our Exhibits 31.1 and 31.2 to Form 10-KSB as attached hereto as
Attachment A.

Preferred Stock Update:

As an update to our previous response to prior comment 8 regarding our Series A and B Convertible
Preferred Stock, we would like to obtain your concurrence with the following additional
considerations:

    1)

    In conjunction with the issuance of the Preferred Stock, the holder also received 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 of the Options is fixed at $4.00 per share for the

    Series A Preferred Stock and $3.65 per share for the Series B Preferred Stock. The Option
is only exercisable during the thirty (30) day period commencing on the date the holder of
the Preferred Stock elects to convert such Preferred Stock to common stock. We considered
whether the Preferred Stock and the Option were separate instruments. In examining this, we
primarily considered the fact that while the Preferred Stock could be converted without
exercising the Options, the Options could not be exercised until the Preferred Stock was
converted. In addition, we considered the interdependence of the instruments, including the
effect of the strike price of the Options on a rational investor’s decision to convert the
Preferred Stock (i.e., to maximize value a rational investor likely would not convert until
the stock price was in excess of the strike price in the Options — that is, the Preferred
Stock would only be converted when the Options went in the money). Thus, we believe the
instruments either could not or would not be exercised separately, and thus were in
substance not freestanding. Accordingly, we did not allocate any of the proceeds received
from the issuance of the Preferred Stock to these Options prior to determining the value of
the beneficial conversion feature embedded in the Preferred Stock instruments. Since the
intrinsic value of the beneficial conversion features exceeded the proceeds received from
the issuance of the Preferred Stock instruments, this conclusion had the effect of
allocating 100% of the proceeds received to the beneficial conversion feature, with the
Preferred Stock subsequently accreted to the initial proceeds as an adjustment to net income
available to shareholders.

    2)

    The proceeds allocated to the beneficial conversion feature were $3.2 million and $3.0
million for the Series A and Series B Preferred Stock, respectively. Using the effective
yield method (starting at an initial value of $0.01 to facilitate the mathematical
calculation), the Company should have recorded a deemed dividend to reflect the incremental
return to the preferred shareholders as follows:

    Deemed Dividend

    % of Quarterly

    Quarter

    This Quarter

    Cumulative

    Loss

    % of Equity

    Q2 — ‘04

    $
    1

    $
    1

    —

    —

    Q3 — ‘04

    65

    66

    —

    —

    Q4 — ‘04

    343

    409

    —

    —

    Q1 — ‘05

    2,118

    2,527

    0.1
    %

    0.9
    %

    Q2 — ‘05

    13,166

    15,693

    0.8
    %

    0.9
    %

Given the immaterial nature of the effect of not recording the deemed dividend through June 30,
2005, we would propose to record the deemed dividend on a prospective basis and include the
cumulative impact of the deemed dividend during the quarter ended September 30, 2005. The deemed
dividend that will be recorded during the third quarter will be $98,131 including the $15,693
cumulative effect of the catch-up. Given our anticipated loss for the quarter, we do not believe
that the cumulative effect of the catch-up will exceed 2.0% of the anticipated loss for the third
quarter and 0.4%% of the anticipated loss for the nine months ended September 30, 2005. As noted
above, the impact on the quarterly losses reported in the quarters ended March 31, 2005 and June
30, 2005 was not material and there was no measurable impact on the quarters ended prior to March
31, 2005.

     I believe that this letter is responsive to the Staff’s comments. If I can be of assistance in
facilitating your review of this letter, please contact the undersigned at (302) 266-6000.

    Sincerely,

    /s/ Alan Rae

    Alan Rae

    Chief Executive Officer

Attachment A

Exhibit 31.1

CERTIFICATIONS OF THE CHIEF EXECUTIVE OFFICER PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF
2002

I, Alan Rae, certify that:

1. I have reviewed this report on Form 10-KSB of O2Diesel Corporation;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or
omit to state a material fact necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to the period covered by this
report;

3. Based on my knowledge, the financial statements, and other financial information included in
this report, fairly present in all material respects the financial condition, results of operations
and cash flows of the small business issuer as of, and for, the periods presented in this report;

4. The small business issuer’s other certifying officer and I are responsible for establishing and
maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and
15d-15(e)) for the small business issuer and have:

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and
procedures to be designed under our supervision, to ensure that material information relating to
the small business issuer, including its consolidated subsidiaries, is made known to us by others
within those entities, particularly during the period in which this report is being prepared;

(b) [omitted pursuant to the guidance of Release No. 33-8238 (June 5, 2003)];

(c) Evaluated the effectiveness of the small business issuer’s disclosure controls and procedures
and presented in this report our conclusions about the effectiveness of the disclosure controls and
procedures, as of the end of the period covered by this report based on such evaluation; and

(d) Disclosed in this report any change in the small business issuer’s internal control over
financial reporting that occurred during small business issuer’s most recent fiscal quarter (the
small business issuer’s fourth fiscal quarter in the case of an annual report) that has materially
affected, or is reasonably likely to materially affect, small business issuer’s internal control
over financial reporting; and

5. The small business issuer’s other certifying officer and I have disclosed, based on our most
recent evaluation of internal control over financial reporting to the small business

issu