UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

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FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996
OR
[ ]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NO. 0-21130

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ENERGY BIOSYSTEMS CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

DELAWARE 04-3078857
(STATE OR OTHER JURISDICTION OF (IRS EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)

ENERGY BIOSYSTEMS CORPORATION 77381
4200 RESEARCH FOREST DRIVE (ZIP CODE)
THE WOODLANDS, TEXAS
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)

(281) 364-6100
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)

----------------------

SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:

Title of Class
Common Stock, par value $.01 per share
Preferred Stock Purchase Rights

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No______
------

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulations S-K is not contained herein, and will not 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-K or any amendment to this
Form 10-K. [ ]

The aggregate market value of the voting stock held by non-affiliates of the
registrant was approximately $75,573,256 as of March 14, 1997, based on the
closing sales price of the registrant's common stock on the Nasdaq National
Market on such date of $6.75 per share and assuming full conversion of the
registrant's Series A and Series B Convertible Preferred Stock. For purposes of
the preceding sentence only, all directors, executive officers and beneficial
owners of ten percent or more of the common stock are assumed to be affiliates.
As of March 14, 1997, 11,605,377 shares of common stock were outstanding, 2,000
shares of Series A Convertible Preferred Stock were outstanding and 702,100
shares of Series B Convertible Preferred Stock were outstanding.

Certain sections of the registrant's definitive proxy statement relating to
the registrant's 1997 annual meeting of stockholders, which proxy statement will
be filed under the Securities Exchange Act of 1934 within 120 days of the end of
the registrant's fiscal year ended December 31, 1996, are incorporated by
reference into Part III of this Form 10-K.

When used in this document, the words "anticipate," "believe," "expect,"
"estimate," "project" and similar expressions are intended to identify forward-
looking statements. Such statements are subject to certain risks, uncertainties
and assumptions. Should one or more of these risks or uncertainties
materialize, or should underlying assumptions prove incorrect, actual results
may vary materially from those anticipated, believed, expected, estimated or
projected. For additional discussion of such risks, uncertainties and
assumptions, see "Item 1. Business--Risk Factors" included elsewhere in this
report.

PART I.

ITEM 1. BUSINESS

OVERVIEW

Energy BioSystems Corporation ("EBC" or the "Company") is developing and
commercializing innovative biotechnology-based processes for the petroleum
refining and production industries. The Company's focus to date has been on
developing biocatalytic desulfurization ("BDS"), a proprietary process involving
the use of enzymes to remove sulfur from petroleum. EBC believes that BDS can
be used as a substitute for, or in conjunction with, existing desulfurization
technology and expects BDS to be significantly less expensive than conventional
desulfurization methods. The Company's BDS pilot plant, which is a fully
integrated desulfurization unit capable of processing up to five barrels of
diesel fuel per day, was completed in late 1994 and began processing diesel
feedstock in March 1995. The pilot plant is intended to provide the basis for
the design of a commercial-scale BDS unit.

Removal of sulfur is one of the most costly issues facing the petroleum
industry and is a growing problem worldwide. Sulfur removal is desirable to the
refining industry because of (i) environmental regulations mandating decreased
sulfur in refined products, (ii) an increasing level of sulfur in crude oil
processed by refiners and (iii) high operating and maintenance costs associated
with the existence of sulfur in petroleum. Desulfurization is also attractive
to the crude oil production market, where low-sulfur crude oil commands a
premium price over high-sulfur crude oil.

The Company has entered into a number of strategic alliances with recognized
industry leaders in support of the Company's BDS development and
commercialization activities, providing an opportunity for the Company to build
on established expertise and resources in critical areas. The Company has an
agreement with The M.W. Kellogg Company ("M.W. Kellogg") for the basic
engineering services necessary for BDS implementation at customer sites, and an
agreement with Petrolite Corporation ("Petrolite") relating to the development
of the Company's BDS technology and the construction and operation of the
Company's pilot plant. The Company also has entered into collaborations
focusing on the application of the BDS technology as follows: an alliance with
Total Raffinage Distribution, S.A. ("Total") to develop a BDS process for diesel
fuel streams; an alliance with Koch Refining Company ("Koch") to develop a BDS
process for certain gasoline streams; an alliance with the Exploration and
Production Technology Division of Texaco Inc. ("Texaco") to develop a BDS
process for crude oil; and an alliance with The Carbide/Graphite Group, Inc.
("Carbide/Graphite") to develop a BDS process for decant oil. The Company is
pursuing additional alliances with potential customers, particularly in the
Middle East and Asia, two markets which are expected to make significant
investments in desulfurization technology over the next decade. The Company is
also pursuing agreements with leading worldwide biocatalyst manufacturers to
ensure a continuous supply of biocatalyst for the Company's BDS process. See "-
- -Alliances."

To date, the Company has engaged primarily in research and development related
to its BDS process. The Company's BDS process will require substantial
additional research, development and testing in order to determine its
commercial viability. See "--Risk Factors--Technological Uncertainty; Risks
Associated with Commercialization of BDS Technology."

The Company was incorporated in Delaware on December 20, 1989. The Company's
executive offices are located at 4200 Research Forest Drive, The Woodlands,
Texas 77381 and its telephone number is (281) 364-6100.

-1-

THE COMPANY'S TECHNOLOGY

Background of BDS

The first patents covering the use of bacteria to reduce the sulfur content of
petroleum were issued in the United States in 1948. However, early attempts to
utilize bacteria and enzymes to selectively remove sulfur from hydrocarbons
failed, primarily because of an inability to control the action of the bacteria,
which resulted in significant degradation of the fuel value of the hydrocarbon.
In 1988, researchers at the Institute of Gas Technology ("IGT") achieved a
breakthrough in microbial desulfurization when they isolated two unique strains
of bacteria. These strains have the ability to desulfurize coal and selectively
remove sulfur from dibenzothiophene, the industry-recognized model for
heterocyclic sulfur molecules found in coal and petroleum. U.S. patents were
issued on these two bacterial strains in 1992.

In 1991, the Company obtained exclusive, worldwide, royalty-free rights to
IGT's desulfurization technology. A critical milestone was achieved in 1992
when the relevant genes from the patented bacteria were cloned and sequenced.
These genes have now been characterized extensively. The cloned genes are now
being manipulated and transferred to alternative microbial hosts and modified to
increase the expression of the desired properties. The Company has been issued a
fundamental patent on these genes, plus numerous other patents on the BDS
process by the U.S. and foreign patent offices. With bacteria strain isolation
and molecular cloning of the genes achieved, further development of BDS
technology involves primarily a new combination of established biotechnology and
chemical engineering processes.

In late 1992, the Company initiated operations of a continuous bench-scale
unit capable of desulfurizing up to one-half of a barrel of crude oil per day.
A fully integrated BDS pilot plant capable of processing up to five barrels of
diesel fuel per day was constructed in late 1994 and began processing diesel
feedstock for desulfurization in March 1995. The pilot plant was designed with
the instrumentation and scale necessary to provide the operating data needed for
commercial scale-up. The pilot plant is utilizing diesel fuel from the
Company's strategic ally, Total, as feedstock, and is undergoing a variety of
experiments that will allow the Company's team of scientists and engineers to
evaluate the performance of the biocatalyst, the reactor and the separations
systems for a wide range of operating conditions. The information generated
from the pilot plant will also be used to guide further development of the
Company's other BDS applications for crude oil and other petroleum products.

Overview of the Company's BDS Technology

BDS is a proprietary process based on naturally occurring bacteria that can
remove organically bound sulfur from petroleum without degrading the fuel value
of the hydrocarbon. Enzymes in the bacteria selectively cleave carbon-sulfur
bonds in the presence of oxygen to yield an oxygenated hydrocarbon product and a
sulfate by-product. Because the chemical reaction is catalyzed by enzymes
associated with the bacteria, the bacteria do not have to grow in order to
desulfurize fossil fuels. Operating at ambient temperatures and atmospheric
pressure, BDS is expected to be significantly lower in cost than conventional
hydrodesulfurization ("HDS") technology and flexible enough to desulfurize a
wide range of petroleum streams including crude oil. Since the process is
oxidative, the addition of hydrogen is not required, thus avoiding a significant
element of conventional desulfurization operating costs.

The basic steps of the BDS process are:

The biocatalyst is combined with water and transferred to the bioreactor.

The biocatalyst slurry and high-sulfur petroleum stream are mixed in the
continuous stirred-tank bioreactor and air is sparged in as a source of
oxygen.

The desulfurized oil is separated from the oil/aqueous/biocatalyst output
stream.

The aqueous phase is further treated to separate out the biocatalyst and
water.

-2-

The sulfur byproduct is captured from the aqueous phase as a sulfate salt
or other water-soluble sulfur compound and removed from the process.

The biocatalyst and water are recycled to the bioreactor and spent
biocatalyst is drawn off.

Conventional Desulfurization Technologies

Hydrotreating is the conventional technology for the removal of sulfur,
nitrogen and other impurities from oil. When this process is used primarily for
the removal of sulfur, it is called hydrodesulfurization ("HDS"). In this
process, petroleum fractions are subjected to high temperatures and pressure in
the presence of an inorganic catalyst and hydrogen. As a result, organic sulfur
molecules are converted to hydrogen sulfide, which is further processed to yield
elemental sulfur. HDS is relatively ineffective against more complex sulfur
molecules found in diesel and heavier fractions.

HDS is a costly process for refiners. A typical HDS unit costs between $30
million and $80 million to construct, depending on the product stream to be
treated, the level of desulfurization required and the unit size. The high
pressure and temperature required for HDS translate directly into high capital
and maintenance costs because these units require high-pressure vessels and
exotic metals which are expensive to manufacture and maintain. Although some
refinery units produce hydrogen, the large amount of hydrogen required for HDS
may require refiners to build new hydrogen production capacity at an additional
significant capital expense.

Benefits of BDS

The Company believes that its BDS technology will offer the refining industry
an effective alternative to HDS and will in many cases complement existing
technology. The Company believes that BDS may provide refiners with the
following principal benefits:

Cost Effectiveness. BDS is designed to operate at ambient temperatures and
pressures, in contrast to HDS, which requires thick-walled reactors and other
equipment designed to tolerate high temperatures and pressures. As a result,
the Company expects that its BDS units will be significantly less expensive to
build than HDS units. The Company expects that the capital costs of a BDS
unit will be approximately 50 percent less than a comparable HDS unit. In
addition, the BDS process will not require hydrogen, which is an expensive
component of HDS.

Ease of Integration. The Company believes the BDS process can be integrated
into refinery operations without significant difficulty. Most of the
components of the BDS units are expected to be readily available equipment.
The biocatalyst will be produced off-site and delivered to the refinery, as is
now the case with inorganic catalysts used in conventional refinery processes.
The BDS process is not expected to generate any unusual byproducts, and
byproduct disposition is expected to be accomplished with existing processes
familiar to most refiners. The mild operating conditions of BDS are also
expected to contribute to improved operating safety over HDS in many
applications.

Effectiveness Against Complex Sulfur Molecules. The Company believes that BDS
will be effective in removing complex sulfur molecules that are resistant to
conventional desulfurization technologies. Diesel fractions, for example,
contain more complex sulfur molecules against which HDS is relatively
ineffective. As a result, HDS becomes increasingly more costly and less
effective in desulfurizing diesel fuel as the lighter-sulfur compounds are
removed and the remaining complex molecules constitute an increasing
proportion of the remaining sulfur. Accordingly, the Company expects that any
reduction in the level of sulfur permitted under applicable regulations will
make BDS increasingly cost-effective as compared to HDS.

While the Company believes its BDS process will be economically attractive to
petroleum refiners and to crude oil producers, the BDS process will require
significant capital expenditures by refiners and producers. The refining and
oil production industries historically have been reluctant to accept new
technologies. There is a risk, therefore, that the Company will have difficulty
in obtaining the refining and oil production industries' acceptance of the BDS
process.

-3-

Also, the rate of purchase of the Company's BDS process may be affected by
economic conditions in the refining and oil production industries. The refining
and oil production industries have been subject to periods of depressed
profitability and are substantially affected by fluctuations in the price of
crude oil and finished products. Oil production and drilling activity are also
largely dependent on the level and volatility of oil prices.

MARKET OVERVIEW

Refining Industry

One of the principal markets for the Company's BDS technology is the worldwide
refining industry, which processes more than 60 million barrels of crude oil per
day or approximately 22 billion barrels per year. A significant portion of
worldwide refining capacity is concentrated among a small number of large
corporations and nationalized oil companies. In the United States, the top 10
companies process approximately 60 percent of the refined petroleum products,
and in Western Europe and Asia, the 10 largest refining companies process more
than half of the refined petroleum products.

Refineries purchase crude oil and process it into three principal products:
(i) middle distillates (including diesel fuel), (ii) gasoline and (iii) residual
fuel oil (used primarily by electric utilities and ships). In the refining
process, crude oil is subjected to distillation, resulting in the separation or
fractionation of the hydrocarbons into several intermediate products. These
intermediate products are subjected to additional processing steps before
formulation into finished products. These additional processing steps include
the removal of impurities (such as sulfur, metals and nitrogen), the "cracking"
of large hydrocarbon molecules and the upgrading of lower-quality intermediate
products.

Refinery Desulfurization

The refining industry is expected to spend more than $35 billion in capital
and up to $10 billion annually in operating expenditures for sulfur removal
through the next decade, assuming the use of conventional technologies. Asia
accounts for approximately 40 percent of this total expenditure with Western
Europe and the United States accounting for approximately 30 percent each.

Pollution regulations have increasingly targeted sulfur in fossil fuels due to
its harmful effects on the environment. The combustion of sulfur results in the
emission of sulfur oxides ("SOx"), which are believed to be a cause of "acid
rain" and smog. Regulations issued under the 1990 amendments to the U.S.
federal Clean Air Act (the "Amendments") required a reduction in the sulfur
content of all on-highway diesel fuels to 500 ppm on October 1, 1993, from a
prior national average of over 2,000 ppm. Similar regulations worldwide will
significantly reduce the level of sulfur allowed in certain petroleum products,
including diesel fuel. In Western Europe, diesel fuel was required to meet the
500 ppm specification by October 1996. In Asia, many countries have adopted or
plan to adopt similar sulfur regulations on diesel fuel which will be
implemented in various stages over the next decade. The European Union has
announced its intention to implement regulations requiring the further reduction
in the sulfur content of diesel fuel, with the expectation that the diesel
sulfur specification will be reduced to 350 ppm by the year 2000 and to 100 ppm
by the year 2005. In the past, environmental standards in the larger economies
around the world have tended to follow each other. Therefore, it is possible
that another series of diesel sulfur regulations, similar to those now
anticipated in Europe, will be forthcoming in the U.S. and in Asian countries.

Sulfur also inactivates catalysts contained in automobile catalytic converters
over time, resulting in a significant increase in the emission of unburned
hydrocarbons and nitrogen oxides ("NOx") from automobile tailpipes, which in
turn contribute to smog. The Amendments required a targeted reduction in U.S.
gasoline emissions of 15 percent by the year 1995 and call for a targeted
reduction of 25 percent by the year 2000. The Environmental Protection Agency
(the "EPA") established a detailed model (the "Complex Model") for determining
the emissions of various gasoline formulations to be sold in most large cities
that have not attained certain prescribed levels of improvement in air quality
("Nonattainment Areas"). Use of the Complex Model becomes mandatory starting in
1998 for certifying gasoline sold in Nonattainment Areas, which currently
represents approximately 25 percent of all gasoline produced in the U.S. The
Complex Model explicitly recognizes the detrimental impact of sulfur on gasoline
tailpipe pollution, giving refiners

-4-

incentive to decrease the level of sulfur in gasoline they produce. Regulations
in Europe further limiting sulfur levels permitted in gasoline are anticipated
for the year 2000 and similar regulations may be adopted in Asia. Industry
sources believe that sulfur will play a key role in refiners' plans to reduce
gasoline emissions in the latter part of this decade.

The Amendments, as well as various state and local regulations, generally
limit the atmospheric emission of SOx by stationary sources, such as refineries
and utilities. For example, permit regulations limit allowable SOx emissions
from fluid catalytic cracking units ("FCCUs") (the refinery processing unit for
upgrading heavier oil molecules to gasoline), which may cause refiners to
constrain the output of a unit that is critical to refining profitability. New
or modified FCCUs are also subject to SOx emissions limitations. The Amendments
and state and local regulations also limit the amount of high-sulfur fuel that
electric utilities may burn, restricting one of the refining industry's largest
end markets for residual fuels. Consequently, the value of residual fuel is
significantly affected by its sulfur content.

The increasing average level of sulfur in crude oils is also expected to
stimulate demand for new desulfurization technologies. Low-sulfur crude oils
have traditionally been in greater demand and commanded a price premium over
higher-sulfur crude oils. Over the last decade, the average sulfur content of
crude oil processed by U.S. refiners increased by more than 20 percent. In the
future, refiners worldwide are expected to process increased volumes of high-
sulfur crude oil, raising the demand for additional desulfurization capacity.

Sulfur in crude oil increases refiners' operating costs because of sulfur's
detrimental effect on refinery equipment and catalytic processes. Many sulfur
compounds are corrosive, and the processing of high-sulfur crude oil
necessitates more frequent maintenance of refinery processing units. The
presence of sulfur in the feedstock for FCCUs decreases the effectiveness of the
inorganic catalyst used to crack the fuel, increasing the operating cost of the
FCCU and decreasing product yield. Sulfur has a similar degrading effect on
most catalytic processes in the refinery, increasing operating costs on a
variety of key processing units.

Crude Oil Desulfurization

The price of crude oil is affected by its sulfur content. The difference in
price between low-sulfur and high-sulfur crude oils is affected by increasingly
stringent regulation of sulfur content in finished products. Lower-sulfur crude
oils have typically commanded a $1 to $3 per barrel premium in the market
compared to higher-sulfur crude. Over 50 percent of the crude oil produced
worldwide is considered high in sulfur (greater than one percent). The Company
believes the price difference between low-sulfur crude oil and high-sulfur crude
oil will create an incentive for oil producers to reduce the sulfur levels in
their product, resulting in demand for crude oil desulfurization technologies.
Accordingly, the Company believes that by reducing the sulfur content of crude
oil at the production stage, BDS has the potential to greatly improve the
marketability and value of higher-sulfur oil reserves and improve producers'
access to pipelines that limit the sulfur content of crude oil. To date,
conventional desulfurization technologies have not proven economically viable
for the desulfurization of crude oil.

Large reserves of high-sulfur crude oil exist in Venezuela, Canada, the United
States, Mexico, the former Soviet Union and the Middle East. Venezuela has
proven reserves in excess of one trillion barrels of crude oil with a sulfur
content greater than two percent. Canada has in excess of 50 billion barrels of
proven reserves of crude oil with a two percent or greater sulfur content, and
the United States has approximately 125 billion barrels of proven reserves of
crude oil with a two percent or greater sulfur content. Cost-effective
desulfurization technology will play a key role in making many of these high-
sulfur crude oil reserves more economically exploitable.

Other Potential Applications of Biorefining

The Company believes there are numerous other applications for its biorefining
technology. These potential applications include the following:

-5-

Nitrogen Removal. Nitrogen compounds in petroleum present refiners with many
of the same problems associated with sulfur. Refiners currently remove nitrogen
using a hydrotreating process. The Company believes that a system similar to the
BDS system can be developed to remove nitrogen.

Metals Removal. Heavy metals in petroleum damage refinery catalysts and
reduce the value of refined petroleum products. In addition, heavy metals limit
the efficiency of conventional desulfurization technologies. Bioreactor systems
have been developed for the extraction of metals from wastewater. The Company
believes that similar systems can be developed for the biocatalytic removal of
metals from crude oil and residual oil.

Viscosity Reduction and Cracking. Bioprocessing technologies have been used
for many years to depolymerize very viscous solutions of corn starch to produce
high fructose corn syrup. A similar chemical process in refineries is called
cracking, which refers to the thermal degradation of complex hydrocarbon
molecules into simpler, higher-value products. The Company believes that a
biocatalytic liquefaction system could be applied to molecules in some highly
viscous crude oils which currently have little commercial value. The Company
believes that this process could produce crude oil with significantly reduced
viscosity, a higher proportion of molecules in the gasoline and diesel fuel
boiling range, and increased commercial value.

Coal Desulfurization. Conventional desulfurization technologies cannot
economically remove organic sulfur from coal. Therefore, high-sulfur coal
represents a potential future market for the Company's desulfurization
technology. The Company believes that the BDS technology it develops for liquid
fossil fuels may eventually have application in the desulfurization of coal and,
in particular, coal slurries.

BUSINESS STRATEGY

The Company's goal is to become the leading provider of biorefining solutions
for the petroleum industry. The Company's strategy is to concentrate its
internal resources on the research, development and marketing of the Company's
BDS technology while entering into strategic alliances to assist in the
engineering and construction of BDS units and in the manufacturing of the
biocatalyst employed in the BDS process. To commercialize BDS, the Company must
develop the BDS process to a competitive commercial level, establish the
infrastructure required to deliver, supply and service the BDS units, and sell
the BDS units to refiners and oil producers. The Company believes it has chosen
the most rapid commercialization strategy by working on these efforts in
parallel and leveraging internal resources with strategic alliances.

The Company believes that its technology has broad potential application in
the processing of petroleum products. Although the Company's technology will
first be directed at biocatalytic desulfurization, the Company's long-term plan
is to expand the capabilities of its technology to address the removal of other
petroleum impurities (e.g., nitrogen and metals), to address other refining
processes (e.g., viscosity reduction and cracking) and to remove sulfur from
coal.

RESEARCH AND DEVELOPMENT

To commercialize BDS, the Company must improve the productivity of the
biocatalyst to a competitive economic level while developing an engineered
bioreactor system that allows the control of several variables to induce optimal
biocatalytic desulfurization. To accomplish these goals, the Company has
conducted extensive research, development and testing of the biocatalyst and
bioreactor and has assembled a team of scientists and engineers with extensive
experience in microbial physiology, molecular biology, biochemistry,
fermentation, process development and scale-up, biochemical engineering,
separations technology, and refinery process engineering and operations.

The focus of the Company's research and development efforts has been to
develop the BDS process for use in treating diesel fuel, gasoline and crude oil.
The Company also has efforts underway to develop the BDS process for use in
treating decant oil under its collaboration with Carbide/Graphite. The Company
expects the desulfurization of diesel fuel, where its development efforts are
the most advanced, to be the first commercial application of its BDS technology.
As a result of the specificity of the biocatalyst for each product application,
the Company expects that further development will be required to commercialize
its BDS technology for use in treating gasoline and crude oil.

-6-

In late 1992, the Company initiated operations of a continuous bench-scale
unit capable of desulfurizing up to one-half of a barrel of crude oil per day.
A fully integrated BDS pilot plant capable of processing up to five barrels of
diesel fuel per day was constructed in late 1994 and began processing diesel
feedstock for desulfurization in March 1995. The pilot plant was designed with
the instrumentation and scale necessary to provide the operating data needed for
commercial scale-up. The pilot plant is utilizing diesel fuel from Total as
feedstock, and is undergoing a variety of experiments that will allow the
Company's team of scientists and engineers to evaluate the performance of the
biocatalyst, the reactor and the separations systems for a wide range of
operating conditions. The information derived from operating the pilot plant
will provide the design basis for the first commercial units and will be used to
guide further development of the Company's other BDS applications for crude oil
and other petroleum products.

In 1994, the Company was awarded a $2 million federal grant under the Advanced
Technology Program ("ATP") administered by the National Institute of Standards
and Technology. The grant is dedicated to the development of a biotechnology-
based method of removing sulfur from crude oil. The three-year program funded
with this award is intended to accelerate the pace of development in crude oil
desulfurization, moving the BDS technology in this area from the research level
toward the pilot plant phase.

The Company had research and development expenses for the years ended December
31, 1994, 1995 and 1996 of $5,723,131, $7,338,319 and $9,210,227, respectively.
The Company expects its research and development expenditures to decrease in
1997, as a result of a nonrecurring $1,000,000 payment to Petrolite in 1996
offset in part by additional scientific and technical personnel and a recently
completed 4,500 square-foot expansion of the Company's laboratory facilities.
The Company's research and development expenses will increase substantially,
however, if the Company makes the $9,000,000 payment to exercise the Petrolite
option in 1997, the entire amount of which will be recorded as a research and
development expense. The Company does not presently intend to exercise the
Petrolite option until it has raised additional funds or received additional
capital.

Biocatalyst Productivity

The Company is focusing on maximizing the biocatalyst's productivity to
minimize the quantity of catalyst and the time needed to complete the reaction.
This biocatalyst strain improvement is being pursued through both conventional
and genetic engineering programs. The conventional programs rely on mutagenesis
to produce variants of the original bacteria that desulfurize more efficiently.
The molecular biology program has identified the genetic elements responsible
for desulfurization, and is pursuing direct improvements in their operation,
primarily through recombinant DNA techniques patented by the Company.
Additionally, fermentation development is being used to identify growth media
which optimize the production of the biocatalyst.

Development of BDS entails research and development in the areas of molecular
biology, biochemistry, fermentation and longevity of the biocatalyst. Set forth
below is a description of the Company's research in these areas.

Increasing the Specific Activity of the Biocatalyst. The understanding and
manipulation of the molecular biology involved in the BDS process is vital for
the successful commercialization of the BDS technology. The Company has cloned,
sequenced and characterized genes responsible for the desulfurization activity.
The genes are now being manipulated, transferred to alternative microbial hosts
and modified to increase the expression of the desired properties. Over the
past three years, the Company isolated, purified and characterized three key
enzymes used in the BDS process. Additionally, in 1995 the Company identified,
isolated, characterized and cloned the gene responsible for the expression of a
previously unrecognized fourth enzyme that increases the rate of the BDS
process. By manipulating the genes responsible for desulfurization activity to
increase the expression of the fourth enzyme and by transferring the
desulfurization genes to alternative microbial hosts, the Company increased the
productivity of the biocatalyst by a factor of ten in 1996. The Company's
ability to make the BDS technology commercially viable will depend in large part
on its success in manipulating these genes to increase the expression of the
desulfurization trait.

Production of the Biocatalyst. Large-scale growth and production, or
fermentation, of biocatalysts is essential to the commercialization of the BDS
technology. The Company's efforts in developing alternative microbial hosts
have been intended to select hosts that can be produced more rapidly and at
lower cost. The Company believes that this

-7-

fermentation will not be substantially different from the many antibiotic and
enzyme fermentations routinely commercialized by other biotechnology companies.
The Company currently conducts small- and intermediate-scale (300 liter)
fermentations at its laboratory facilities. These facilities are sufficient to
supply laboratory and preliminary pilot plant needs for the biocatalyst. The
Company is pursuing agreements with leading worldwide biocatalyst manufacturers
to ensure a continuous supply of biocatalyst for the Company's BDS process.

Longevity of Biocatalysts. All catalysts become inactive after prolonged
exposure to hydrocarbons. Catalyst replacement is a significant factor in the
cost of BDS. By extending the longevity of the biocatalyst, this component of
the operating cost of BDS can be minimized. The Company is developing
resistant strains of bacteria to serve as hosts, or "platforms," for the
desulfurization enzymes in order to maximize the longevity of the biocatalyst in
diesel fuel.

Process Engineering

In addition to efforts in biocatalyst development, the Company has allocated
considerable resources to the development of the process engineering for the
first BDS units. The Company believes that scale-up of its BDS process can be
accomplished with conventional process engineering technology. The Company and
Petrolite jointly operate the BDS pilot plant, which is a fully integrated
desulfurization unit capable of processing up to five barrels of diesel fuel per
day. The pilot plant was completed in late 1994 and began processing diesel
feedstock in March 1995. The pilot plant is intended to provide the basis for
the design of a commercial-scale BDS unit. Although many aspects of the
bioreactor are standard, the specific configuration of the bioreactor to be used
at each site will be customized based on, among other things, the specific
petroleum fraction to be desulfurized and the configuration of the refinery.

Bioreactor Technology. The Company has designed and constructed the pilot
plant to develop the catalytic process with hydrocarbon molecules in the
presence of air, water and various process chemicals. Variables such as
temperature, agitation rate and pH (acidity or alkalinity) can be controlled,
and measured amounts of oxygen and process chemicals can be added to the mixture
of biocatalyst and petroleum, optimizing the desulfurization environment. The
Company, however, has not yet developed a bioreactor capable of operating at
commercial levels of throughput and desulfurization, and there can be no
assurance that the Company can develop a commercial-scale bioreactor that will
desulfurize petroleum on a commercial basis.

Separations Issues. The completion of the BDS process results in a mixture of
water, desulfurized hydrocarbons, biocatalyst and sulfur byproduct. The Company
has developed proprietary technology for the efficient separation of these
components. The Company's improved separations system has been demonstrated in
the laboratory and was successfully implemented at the Company's pilot plant in
1996. The separation process uses a unique combination of conventional
technologies which the Company believes can be scaled up to commercial levels
without substantial difficulty.

Byproduct Disposition. The principal by-product of the BDS process is a
water-soluble, inorganic sulfur compound which has been removed from the target
hydrocarbons. The Company has evaluated alternatives for the disposition of the
sulfur and believes that the best alternative for most refineries will be
conversion of the sulfur byproduct either to ammonium sulfate, which can be used
as a fertilizer, or to sodium sulfate. A secondary byproduct will be the spent
biocatalyst stream, which is expected to be disposed of at an off-site
commercial disposal facility as either a solid or other refinery waste.

Mass Transfer Issues

The Company's recent success in improving the productivity of the biocatalyst
has increased the intrinsic reaction rate of the biocatalyst to the point that
it exceeds the rate at which sulfur molecules transfer from the petroleum to the
surface of the biocatalyst. Limitations in the speed of a catalytic reaction as
a result of the rate at which a substrate transfers to a catalyst (known as
"mass transfer limitations") are commonly encountered in both biological and
chemical catalysis and can frequently be overcome through one or more commonly
used biological and chemical engineering solutions. The Company is modifying
both the biocatalyst and the reactor design in an effort to overcome the mass
transfer limitation that currently affects the rate of the BDS reaction.

-8-

Scientific Advisory Board

The Company has retained a group of distinguished research scientists and
engineers to provide advice on matters relating to its research, development and
business activities. The Scientific Advisory Board, composed of six members,
meets with the Company's scientists and management and is regularly available
for consultation. Scientific advisors are compensated for expenses and certain
advisors have been granted options to acquire Common Stock. The members of the
Scientific Advisory Board are as follows:

Charles L. Cooney, Ph.D., Professor of Chemical and Biochemical Engineering,
Massachusetts Institute of Technology. Dr. Cooney is widely recognized as an
expert in the field of bioreactor design and engineering. Dr. Cooney is the
author or co-author of more than 200 scientific publications and patents and has
received many academic awards and honors, including being named Founding Fellow,
American Institute for Medical and Biological Engineering, in 1992. Dr. Cooney
received his B.S. in Chemical Engineering from the University of Pennsylvania
and his M.S. and Ph.D. in Biochemical Engineering from Massachusetts Institute
of Technology.

Norman Hackerman, Ph.D., President Emeritus and Distinguished Professor
Emeritus of Chemistry, Rice University, and Former President and Professor
Emeritus of Chemistry, The University of Texas at Austin. Dr. Hackerman is a
member of the National Academy of Sciences and of the American Philosophical
Society, a Fellow of the American Academy of Arts and Sciences, and Chairman of
the Scientific Board of the Robert A. Welch Foundation. Dr. Hackerman has been
the recipient of many awards, including the American Institute of Chemists Gold
Medal and the Mirabeau B. Lamar Award of the Association of Texas Colleges and
Universities. He received his A.B. and Ph.D. from Johns Hopkins University.

Herbert L. Heyneker, Ph.D., Visiting Scholar, Standford University School of
Medicine, Department of Genetics. Dr. Heyneker is an authority in microbial
expression of human proteins, including insulin, growth hormone and tPA; protein
engineering; and expression systems for industrial microorganisms. Dr. Heyneker
serves as a director of Genpharm International, Inc., and Genomysx Corporation.
He also serves as a scientific advisor for Institutional Venture Partners and as
a member of the scientific advisory board for Cytel Corporation. He earned his
Ph.D. from the University of Leiden, The Netherlands and completed his post-
doctoral fellowship at the University of California-San Francisco Medical
School.

Charles F. Kulpa, Jr., Ph.D., Professor of Microbiology, University of Notre
Dame. Dr. Kulpa is regarded as an expert in the fields of microbiology,
bioremediation and biochemistry. His laboratory research work is concentrated in
the areas of environmental and applied microbiology. Dr. Kulpa has authored or
co-authored numerous papers detailing his research in microbiological and
biochemistry processes. Active in many scientific organizations, Dr. Kulpa has
served as President of the Indiana Branch of the American Society for
Microbiology. He received his B.S., M.S. and Ph.D. in Microbiology from the
University of Michigan.

W. Arthur Porter, Ph.D., President and Chief Executive Officer of the Houston
Advanced Research Center. The Houston Advanced Research Center ("HARC") is a
non-profit research consortium with major research interests in materials
science, lasers, high energy physics, supercomputing, geotechnology, space and
policy studies located in The Woodlands, Texas. Dr. Porter is also adjunct
professor of electrical and computer engineering at Rice University in Houston.
Dr. Porter serves on the boards of Stewart Information Services Corporation;
Electro Scientific Industries; HARC; and the American Productivity and Quality
Center. He also serves as a Governor-appointed member of the Texas Partnership
for Economic Development Board and is a past member of the U.S. Department of
Commerce Semiconductor Technical Advisory Committee. He received his B.S. and
M.S. degrees in Physics from the University of North Texas and his Ph.D. in
Interdisciplinary Engineering from Texas A&M University.

-9-

Derek Redmore, Ph.D., Vice President, Technology Department, Petrolite. Dr.
Redmore has served at the managerial level within Petrolite since he joined the
company as a Senior Research Chemist in 1965. During his career, he has received
108 patent awards and was named Missouri Inventor of the Year in 1981. He
received his B.Sc. and Ph.D. in Chemistry from Nottingham University in England
and completed his post-doctoral work at Washington University in St. Louis.

ALLIANCES

The Company has entered into alliances with potential customers and suppliers
in support of its BDS development and commercialization activities. These
alliances give the Company an opportunity to build on established expertise and
resources in areas critical to its success. In the case of alliances with
potential customers, the Company believes that these relationships may enhance
its ability to sell BDS units. Entering into alliances with recognized industry
suppliers is expected to facilitate commercialization of the BDS technology.
However, there can be no assurance that the Company will be successful in
maintaining its existing collaborative relationships or in establishing new
relationships.

Alliances with Potential Customers

Total Raffinage Distribution S.A. In July 1994, the Company entered into an
agreement with Total Raffinage Distribution S.A. ("Total") to collaborate on the
application of the Company's BDS process to diesel and other middle distillate
fuel streams. The Company and Total will each bear their own costs and expenses
incurred under the collaboration. In addition, as part of its obligations under
the agreement, Total has provided the Company with the use of analytical
equipment valued at approximately $200,000. The agreement with Total provides
that upon commercialization, the site licenses will be waived on Total's first
commercial BDS unit. In addition, Total will be entitled to receive a 10
percent discount on future site license and service fees until it has recovered
two and one-half times its research costs and expenses for BDS projects under
the agreement. The Company expects that its alliance with Total will facilitate
commercialization of the BDS technology for diesel fuel and the Company's
entrance into the European market.

The Company's alliance agreement with Total contemplates an evaluation of
pilot plant operations, commencing after the Company's completion of the
development of a prototype biocatalyst. The Company completed the development
of a prototype biocatalyst in late 1996 and expects to complete the evaluation
by mid-1997. The prototype biocatalyst is intended to possess characteristics
sufficiently similar to the commercial biocatalyst to permit the design of a
commercial-scale BDS unit although it is not expected or intended to possess
sufficient specific activity or other characteristics necessary to be
commercially viable. If the results from the pilot plant are satisfactory, it
is expected that Total will build and operate at Total's expense a pilot BDS
unit at Total's European Center for Research and Technology and simultaneously
will build a commercial BDS unit at one of its refineries. The Company intends
to continue the development of the biocatalyst to improve its specific activity
and other characteristics necessary for commercial viability during the period
in which Total is building these BDS units. Total has indicated that it intends
to employ its initial BDS units for the "ultra deep" (below 500 ppm)
desulfurization of diesel, a range of desulfurization below current regulatory
standards in which BDS is expected to possess greater cost advantages as
compared to HDS. The Company is also continuing to develop its BDS technology
for the desulfurization of diesel fuel in ranges above 500 ppm.

Total is a wholly owned subsidiary of Total S.A., a leading international oil
and gas company based in France. Total S.A. participates in every phase of the
oil and gas industry with operations in more than 80 countries worldwide and
revenues of over $25 billion.

Koch Refining Company. In December 1993, the Company entered into an alliance
with Koch Refining Company ("Koch") for the development of a biotechnology-based
desulfurization system for refinery oil streams. The alliance is expected to
accelerate the development of BDS for certain gasoline streams and customize
that development for Koch's applications. Under the terms of the alliance, the
Company is primarily responsible for improving the performance of the
biocatalyst used in the BDS process and developing a commercial BDS system.
Koch is primarily

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responsible for selecting and providing the target gasoline stream as well as
testing desulfurized product quality. Koch will also provide engineering support
as needed in the development of a BDS unit for Koch's operations. Until
commercialization, the Company and Koch will each bear their own costs and
expenses incurred in connection with the collaboration. Upon commercialization,
Koch will be repaid for direct costs and expenses incurred in assisting BDS
development. Repayment will be in the form of a 10 percent rebate on
desulfurization processing fees charged to Koch until Koch has been repaid its
share of BDS development costs. The Company expects that the development
alliance with Koch will facilitate commercialization of the Company's BDS
technology for target gasoline streams.

Koch is a part of Koch Industries, one of the largest privately held companies
in the United States. Koch Industries, with annual revenues in excess of $20
billion, is involved in virtually all phases of the oil and gas industry, as
well as chemicals, chemical technology products, agriculture, hard minerals,
real estate, and financial investments.

Texaco Exploration and Production Technology Division. In July 1993, the
Company signed an agreement with the Exploration and Production Technology
Division of Texaco Inc. ("Texaco") for the development of a BDS process for
crude oil. Under the terms of the alliance, the Company is primarily
responsible for improving the performance of the biocatalyst used in the BDS
process. Texaco is primarily responsible for field operations, analytical
chemistry work, and selecting and providing the target crude oil stream as well
as testing desulfurized product quality. Process engineering is conducted
jointly by the parties. The Company and Texaco each bear their own costs and
expenses incurred in connection with the collaboration. In the event the
Company sub-licenses Texaco's intellectual property and proprietary information,
licensed by Texaco to the Company, the Company has agreed to pay Texaco an
amount equal to 10 percent of the desulfurization processing fee charged to
Texaco until such time as the Company has paid Texaco an aggregate amount equal
to two and one-half times the aggregate amount of Texaco's direct costs and
expenses incurred in connection with the collaboration. The Company expects
that the development alliance with Texaco will facilitate commercialization of
the Company's BDS technology for crude oil applications.

Texaco Inc. is one of the largest oil companies in the world with operations
in crude oil production, refining and marketing. Texaco Inc. has annual
revenues in excess of $36 billion.

The Carbide/Graphite Group, Inc. In December, 1995, the Company entered into
an agreement with The Carbide/Graphite Group, Inc. ("Carbide/Graphite") to
collaborate on the development of the Company's BDS technology for the removal
of sulfur from decant oil. Decant oil is a heavy, highly viscous refined
petroleum product which is used primarily to make needle coke. Needle coke is
the principal raw material used in the manufacture of graphite electrodes.
Under the terms of the alliance, the Company will be primarily responsible for
customizing and commercializing a biocatalyst and desulfurization system
specifically for decant oil. Carbide/Graphite primarily will be responsible for
providing the development and commercialization funding for this particular BDS
process. The Company expects that the development alliance with
Carbide/Graphite will facilitate commercialization of the Company's BDS
technology for decant oil.

Carbide/Graphite, which has annual revenues in excess of $259 million, is a
major U.S. manufacturer of graphite electrode and calcium carbide products.
Graphite electrodes are used as conductors of electricity, and are consumed in
the electric arc furnace steelmaking process common to all mini-mill steel
producers. Carbide/Graphite is the only manufacturer of graphite electrodes
that produces its own requirements of needle coke. Carbide/Graphite also sells
needle coke to other manufacturers of graphite products.

Prospective Additional Customer Alliances. The Company is pursuing additional
alliances with potential customers, particularly in the Middle East and Asia,
two markets which are expected to make significant investments in
desulfurization technology over the next decade.

Alliances with Suppliers

The M.W. Kellogg Company. In August 1994, the Company signed an agreement
with The M.W. Kellogg Company ("M.W. Kellogg") to collaborate on the development
and commercialization of BDS technology. Under the terms of the collaboration,
M.W. Kellogg will serve as an engineering consultant to the Company during
completion

-11-

of the BDS development process and will be the exclusive provider of the basic
engineering design services required for commercial BDS units. In return for
these services, M.W. Kellogg will receive a portion of the site license fee
generated by the sale of BDS units. The collaboration has a minimum term of at
least five years or the completion of 20 BDS units, whichever is longer, and
applies to all biorefining technologies the Company develops. During the first
phase of the collaboration, M.W. Kellogg provided 500 engineering work hours of
service at no cost to the Company. M.W. Kellogg also agreed to provide an
additional 1,500 work hours of service at M.W. Kellogg offices at reduced rates,
of which 500 had been utilized by the Company at December 31, 1996. The Company
expects that the development alliance with M.W. Kellogg will substantially
enhance its refinery engineering capabilities and market access.

M.W. Kellogg is an ISO 9001-certified, international technology-based
engineering and construction contractor, serving primarily the hydrocarbon,
chemical and energy related industries. M.W. Kellogg is a wholly owned
subsidiary of Dresser Industries, Inc., a major supplier of highly engineered
products and services primarily used in hydrocarbon and energy-related
activities throughout the world. Dresser Industries, Inc. has annual revenues
in excess of $6 billion.

Petrolite Corporation. In March 1992, the Company entered into a
collaboration agreement with Petrolite Corporation ("Petrolite"). The Company
and Petrolite agreed to jointly develop the Company's BDS process and utilize
emulsification and separations technologies and process chemicals developed by
Petrolite, if needed. In connection with this collaboration, Petrolite agreed
to provide the emulsification and separations equipment necessary for the
storage, mixing, injection and delivery of biocatalysts and process chemicals
used in the BDS process and to pay the Company $5.4 million during the first two
years of the agreement for research and development. Petrolite also agreed to
design and finance construction of the pilot plant and to provide service
personnel to operate and service the BDS units on site at customer locations.
The Company agreed to market the BDS process and the Company's biocatalyst, and
to fund, during the third through fifth years of the agreement, research and
development related to BDS at an annual rate of not less than four percent of
the Company's net revenues from BDS projects or $2.5 million, whichever is
greater. Under the collaboration agreement, the Company is obligated to pay
Petrolite 22 percent of all site license fees received by the Company from BDS
customers and 22 percent of adjusted gross profit (as defined in the agreement)
realized from operation of the BDS units. The Company expects that the
development alliance with Petrolite will facilitate commercialization of the
Company's BDS technology through the development and testing of the pilot plant.

In October 1996, the Company entered into an agreement with Petrolite
providing the Company with the option to amend the terms of its strategic
alliance with Petrolite. Under the agreement, the Company made an initial
payment of $1 million to Petrolite in December 1996 in exchange for the option
and the extension of Petrolite's obligations to provide operational and
technical support for the pilot plant from September 1, 1996 through December
31, 1998. If the Company exercises its option, the percentage of site license
fees and adjusted gross profit payable to Petrolite will be reduced to 9.5% from
22%, in exchange for which the Company will (i) assume responsibility for
servicing the BDS units on site at customer locations (ii) pay Petrolite an
additional $9 million in cash and (iii) issue to Petrolite a warrant entitling
Petrolite to purchase 138,889 shares of Common Stock at an exercise price of
$7.20 per share. The Company may exercise the Petrolite option at any time on
or before the earlier to occur of (i) ten business days following the closing of
any equity financing by the Company in which the gross cash proceeds raised in
such financing (together with the gross cash proceeds raised by the Company in
any other equity financing after the date of the option agreement, if
applicable) equal or exceed $25 million and (ii) December 30, 1998.

Petrolite is a refinery services company with over $360 million in annual
revenues. Petrolite's research and development capabilities include process
engineering, emulsification and separations chemistry and analytical chemistry.

Prospective Additional Supplier Alliances. The Company is pursuing agreements
with leading worldwide biocatalyst manufacturers to ensure a continuous supply
of biocatalyst for the Company's BDS process.

COMPETITION

The primary competition for BDS technology is expected to come from licensors
of HDS technology and the manufacturers of catalysts used in those units. In
most initial diesel fuel applications, BDS will be sold as a

-12-

complementary process where expanded capacity is desired or a greater degree of
desulfurization becomes necessary in connection with an existing HDS unit.
Subsequently, BDS will be developed as a stand-alone diesel fuel desulfurization
process, competing directly with HDS. In the case of gasoline, where HDS units
are not typically used, the Company expects BDS to operate as a stand-alone
desulfurization system. The Company intends to compete on the basis of cost
effectiveness, ease of integration, effectiveness in removing complex sulfur
molecules that are resistant to conventional desulfurization technologies, and
the ability to process petroleum streams that are difficult for HDS to process.

HDS process technologies and catalysts are supplied by a small number of
companies that maintain their market positions through a combination of
recognized expertise, intellectual property rights and established relationships
with refiners. Increasing environmental regulation has caused these catalyst
suppliers to make significant investments in research and development during the
past several years to develop more efficient HDS technologies. The Company
believes that these efforts have been directed at refinement of the conventional
HDS technology rather than development of entirely new processes. Many of these
companies supplying HDS technology have substantially greater financial,
technical and human resources than the Company.

BDS may face competition from other biotechnology processes, although the
Company believes it is the leading developer of biorefining in the world. The
most significant competitive effort of which the Company is aware is based in
Japan at the Petroleum Energy Center ("PEC"), a consortium of Japanese petroleum
companies conducting research funded by the Japanese Ministry of International
Trade and Industry. The Company believes, based upon meetings with PEC
personnel and third-party sources, that it has a substantial lead in developing
BDS technology and that its patents provide it with a substantial competitive
advantage over the PEC effort. The Company is also aware that one or more major
oil companies have from time to time attempted to develop microbial or
biocatalytic desulfurization technologies, although the Company believes that
none of these companies has successfully developed any of these technologies to
date. Based upon information available to the Company, the Company believes
that these efforts do not currently present significant competition for its BDS
technology in its primary markets.

PATENTS AND PROPRIETARY TECHNOLOGY

The Company's ability to compete will depend in part on maintaining the
proprietary nature of its technology. The Company has established an active
program for the protection of its intellectual property. This program includes,
among other things: procedures, notebooks and forms for documenting, evidencing
and disclosing all Company inventions to management; a Patent Review Committee
which meets regularly to discuss all intellectual property issues; a system for
continuously monitoring patents issued to, and patent applications filed by,
relevant third parties; a program of seminars for employees on intellectual
property topics; a recognized intellectual property law firm on retainer; a
patent administrator and other personnel dedicated to assisting in the
preparation and prosecution of the Company's patents; personnel policies and
agreements requiring disclosure by employees of all inventions and protection of
confidential information; and agreements with all technical and scientific
employees providing for the assignment of inventions made by such employees to
the Company.

The Company has an active program in place to maintain and build its
intellectual property position. Seven U.S. patents on BDS technology have been
issued to The Institute of Gas Technology ("IGT") and licensed exclusively to
the Company, subject to the U.S. government's rights to certain of such patents.
Additionally, one U.S. patent has been issued to the Korean Institute of Science
& Technology and licensed on a nonexclusive basis to the Company. A U.S. patent
claiming the use of BDS in combination with HDS for BDS technology was issued to
the Company in 1993. The two-stage process for deep desulfurization covered
by this patent involves the use of BDS in conjunction with conventional HDS
technology, taking advantage of the significant synergies between the two
technologies. The Company was issued three patents during the year ended
December 31, 1994 and three patents during the year ended December 31, 1995.
The most significant of the three patents issued in 1994 is the "Recombinant DNA
Encoding a Desulfurization Biocatalyst" patent, which is a fundamental
recombinant DNA patent on the genetic sequences for enzymes that desulfurize
petroleum. This patent is an important milestone in the development of the
Company's worldwide competitive position and establishes its technical
leadership in biodesulfurization. The remaining two patents issued in 1994
include "A Process for the Desulfurization and the Desalting of Fossil Fuels"
and "Microemulsion

-13-

Process for Direct Biocatalytic Desulfurization of Organosulfur Molecules." The
patents issued in 1995 include "Multistage Process for Deep Desulfurization of
Fossil Fuels," "Method for Separating a Sulfur Compound from Carbonaceous
Materials" and "Continuous Process for Biocatalytic Desulfurization of Sulfur-
Bearing Heterocyclic Molecules." In 1996, an additional five U.S. patents were
issued to the Company, including continuations in part on the HDS/BDS patent
first issued in 1993 and the desalting patent first issued in 1994 as well as
two entirely new patents related to oil/water separations technology and a novel
process for the reduction of oil viscosity. These patents are expected to yield
long-term improvement in the economics of biodesulfurization for the Company.
Patents issued to or licensed by the Company begin to expire in the year 2010.

The Company has filed patent applications in the U.S. and worldwide under the
Patent Cooperation Treaty as well as in targeted countries not involved in the
treaty such as Venezuela. In total, the Company has rights to 20 U.S. patents
(including cell recombinant DNA and fundamental process patents) and 32 foreign
patents. In addition, the Company has 12 applications pending in the U.S.
patent office, and more than 60 foreign patent applications pending to cover BDS
process technology and the molecular cloning of the biocatalyst gene. See "--
Risk Factors--Patents and Proprietary Technologies."

EMPLOYEES AND CONSULTANTS

The Company believes that its success will be based, among other things, on
achieving and retaining scientific and technological superiority and on
identifying and retaining capable management in order to conduct a fully
integrated program of biorefining technology development. The Company has
assembled a highly qualified team of scientists as well as executives with
extensive experience in the petroleum industry. The Company's product
development program combines basic scientific disciplines, such as molecular
biology, microbial genetics, biochemistry and biochemical engineering, with
applied disciplines such as fermentation, process development, petroleum product
separations and recovery, and byproduct disposition expertise.

As of December 31, 1996, the Company employed 83 people, 26 of whom hold Ph.D.
degrees and 13 of whom hold other advanced degrees. The Company's employees
with doctoral degrees represent collective expertise in molecular biology,
microbiology, biochemistry, chemistry and chemical and process engineering. The
Company believes that its relationship with its employees is good.

GOVERNMENT REGULATION

Certain of the Company's current and planned operations are, or may be,
subject to regulation under various federal and state laws pertaining to
protection of the environment and employee health and safety. In the course of
its current research and development activities, the Company generates small
quantities of solid and hazardous wastes that are subject to regulation under
the Resource Conservation and Recovery Act ("RCRA") and various other federal
and state regulations. The research and development activities of the Company
are also subject to the Occupational Safety and Health Act ("OSHA") and similar
state laws and regulations. Upon commercialization of the Company's technology,
the Company's operations will be subject to the full scope of environmental and
employee health and safety regulations including not only RCRA and OSHA, but
also the Clean Air Act, the Federal Water Pollution Control Act, the Toxic
Substances Control Act ("TSCA") and other applicable state and federal
environmental laws and regulations. Although current information is not
definitive enough to accurately predict compliance requirements with such laws
and regulations, the Company believes that compliance will not materially affect
its operations.

Under TSCA, the EPA regulates the use of chemicals for commercial purposes,
and the EPA has asserted that it has jurisdiction under TSCA to regulate
genetically engineered microorganisms ("GEMs"). Prior to commercialization of
the Company's biocatalyst product, the Company will most likely be subject to
the Premanufacture Notice Requirements under TSCA in marketing its BDS
technology. Under the Premanufacture Notice Requirements, if the EPA finds that
the Company's biocatalyst product poses an unreasonable risk to the environment,
it may establish controls on its manufacture, distribution or disposal. Based
on written communication with the EPA, the Company does not believe that
compliance with TSCA will delay the commercialization of the BDS process.

-14-

Commercialization of the Company's technology outside the U.S. will require
compliance with the regulations of foreign countries. In anticipation of early
commercialization in Europe, the Company has begun efforts to prepare for
compliance with European Union regulations for genetically modified organisms
("GMOs"). Directive 90/219 of the European Commission provides a framework for
contained use of GMOs. Each of the member countries has enacted specific
regulations consistent with this directive. Based upon discussions with
authorities in France, Belgium and the United Kingdom regarding their
regulations under Directive 90/219, the Company does not believe that compliance
with such regulations will delay commercialization of the BDS process in Europe.

RISK FACTORS

Technological Uncertainty; Risks Associated with Commercialization of BDS
Technology

Since its inception, the Company has engaged primarily in research and
development related to its BDS process. The Company's BDS process will require
substantial additional research, development and testing in order to determine
its commercial viability. The Company has not proven its BDS technology other
than to a limited extent in laboratory, bench-scale and pilot plant trials. The
Company's ability to make its BDS technology commercially viable will depend in
large part on its success in (i) achieving improvement of its biocatalyst,
including the manipulation of the genes responsible for desulfurization activity
to increase the expression and longevity of the desulfurization trait, (ii)
improving the rate at which sulfur molecules transfer from petroleum to the
biocatalyst, (iii) developing the fermentation process, (iv) contracting for the
manufacture of, or manufacturing, sufficient biocatalyst for use in commercial
BDS units, (v) developing a bioreactor for use with the BDS process capable of
operating at commercial levels of throughput and desulfurization, (vi)
identifying economically viable processes for commercial-scale, sulfur byproduct
disposition and (vii) marketing its BDS systems effectively. The accomplishment
of some or all of these objectives may take longer than anticipated or may never
occur. If the accomplishment of any of these objectives takes longer than
anticipated, the Company may require additional capital to continue the
development and commercialization of its BDS technology, and there can be no
assurance that such capital will be available or that the Company will be able
to successfully commercialize the BDS technology.

History of Operating Losses and Uncertainty of Future Profitability

The Company has incurred net losses since its inception and expects its losses
to increase in the foreseeable future as it increases its expenditures for the
continued development and commercialization of its biorefining technology. The
Company has not derived any revenues to date from the use or sale of its
biorefining technology and had an accumulated deficit of $42,713,302 at December
31, 1996. The time required for the Company to become profitable is uncertain,
and there can be no assurance that the Company will achieve profitability on a
sustained basis, if at all.

Manufacture of Biocatalyst

The Company currently intends to manufacture, at its own facility, only a
quantity of biocatalyst sufficient for its in-house research and pilot plant
needs. The Company expects that the biocatalyst to be employed in the
commercial BDS process initially will be manufactured by a third party. The
Company has had discussions regarding non-exclusive biocatalyst supply
arrangements with several parties that it believes are capable of satisfying the
Company's supply requirements. If the Company is unable to enter into
agreements for the supply of commercial quantities of biocatalyst, the Company
may be forced to establish its own fermentation facilities. This alternative
could delay the commercialization of the BDS process and would require
significant capital expenditures.

Market Acceptance

The BDS process will require significant capital expenditures by refiners and
producers. The refining and oil production industries historically have been
reluctant to accept new technologies. There is a risk, therefore, that the
Company will have difficulty in obtaining the refining and oil production
industries' acceptance of the BDS process. Also, the rate of purchase of the
Company's BDS process may be affected by economic conditions in the refining and
oil production industries. The refining and oil production industries have been
subject to periods of depressed

-15-

profitability and are substantially affected by fluctuations in the price of
crude oil and finished products. Oil production and drilling activity are also
largely dependent on the level and volatility of oil prices.

Reliance on Environmental Regulation

Demand for the BDS units and services being developed by the Company is based,
in large part, on legislation and regulations in the United States, Europe and
Asia that specify stringent environmental quality standards and that impose
penalties for noncompliance. The amendments to the federal Clean Air Act
required the EPA to develop maximum sulfur content standards for highway diesel
fuel and new standards for gasoline content. In response, EPA promulgated
regulations regarding the maximum sulfur content of highway diesel fuel in 1990
and regulations for a reformulated gasoline program in 1994. Similar
regulations regarding the maximum sulfur content of diesel fuel have been
adopted in Western Europe and certain Asian countries. The Company also expects
that European and Asian countries will adopt and enforce additional standards
requiring a reduction in the sulfur content of petroleum products. Any
reduction of severity in current regulations, lax enforcement of current
regulations, delay in implementation and enforcement of planned regulations, or
reduction of severity in planned or anticipated regulations worldwide may delay
or decrease the worldwide demand for the Company's BDS process.

Patents and Proprietary Technologies

The Company's success is heavily dependent upon its proprietary BDS and other
technologies. In total, the Company has rights to 20 U.S. and 32 foreign
patents. In addition, the Company has 12 patent applications pending in the
U.S. patent office and more than 60 foreign patent applications pending to cover
BDS process technology and the molecular cloning of the biocatalyst genes.
There can be no assurance concerning the scope, validity or value of such
patents, patent applications or related intellectual property rights.
Furthermore, there can be no assurance that the steps taken by the Company to
protect its proprietary technologies will be adequate to prevent
misappropriation of these technologies by third parties, particularly where
third parties may independently develop similar technologies, duplicate any of
the Company's technologies or design around any proprietary technologies owned
by the Company. Any such misappropriation could have a material adverse effect
on the Company. Although the Company does not believe any of its proprietary
technologies infringe the patent or other proprietary rights of third parties,
there can be no assurance that infringement claims will not be asserted against
the Company in the future or that any such claims will not require the Company
to enter into license arrangements or result in litigation. In the event that
the Company may be required to obtain licenses to patents or other proprietary
rights of third parties, there can be no assurance that any required licenses
would be made available to the Company on terms acceptable to the Company, or at
all. If the Company does not obtain such licenses, it could encounter delays in
commercializing its BDS technology while it attempts to design around such
patents or could find that the commercialization of its BDS technology could be
foreclosed. In addition, to the extent that the Company seeks to protect its
proprietary technologies overseas, there can be no assurance that steps taken by
the Company to protect its proprietary technologies will be adequate under the
laws of certain foreign countries, which may not protect the Company's
proprietary rights to the same extent as do the laws of the United States.

The Company relies on secrecy to protect its proprietary technologies in
addition to patent protection, especially where patent protection is not
believed to be appropriate or obtainable. The Company has entered into
confidentiality agreements with its employees, licensors and certain of its
collaborators and consultants. There can be no assurance that such obligations
of confidentiality will be honored, that other parties will not otherwise gain
access to the Company's trade secrets or that the Company can effectively
protect its rights to its unpatented trade secrets. See " -- Patents and
Proprietary Technology."

-16-

Dependence on Collaborators

The Company has been dependent on collaborative relationships for development
of certain key components of the BDS process, and the Company's
commercialization strategy contemplates continued dependence on collaborative
relationships. The Company has signed an agreement with M. W. Kellogg to
provide the basic engineering designs necessary for BDS implementation at
customer sites and an agreement with Petrolite relating to the development of
the Company's BDS technology and the construction and operation of the Company's
pilot plant. Each alliance partner is currently providing technical assistance
during the development of the BDS process. The Company also has entered into an
alliance with Total relating to the application of the BDS process to diesel
fuel, an alliance with Koch to develop the BDS process for certain gasoline
products, an alliance with Texaco to develop a process for desulfurizing high-
sulfur crude oil, and an alliance with Carbide/Graphite relating to the
development of the BDS process for the desulfurization of decant oil.
Collaborative arrangements involve risks that the participating partners may
disagree on business decisions and strategies, which may result in delays,
additional costs or litigation. The inability of the Company to successfully
maintain existing collaborative relationships or enter into new collaborative
relationships could have a material adverse effect on the Company. See "--
Alliances."

Need for Additional Funds

EBC's operations to date have consumed substantial amounts of cash. The
negative cash flow from operations is expected to continue over the foreseeable
future. The Company believes that its existing capital resources will be
sufficient to fund its operations through year-end 1998. Thereafter, the
Company may need to raise additional funds to continue development and
commercialization of its biorefining technology. The Company may seek
additional funding through public or private financings, including equity
financings, and through collaborative arrangements. Adequate funds for these
purposes, whether obtained through financial markets or collaborative or other
arrangements with corporate partners or from other resources, may not be
available when needed or on terms acceptable to the Company. The Company's
inability to raise funds when needed may require the Company to delay, scale
back or eliminate some or all of its research and product development programs.
See "Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations."

Limited Marketing Experience

The Company has only limited experience marketing its BDS technology, and has
assembled only a small sales and marketing staff. There can be no assurance
that the Company will be able to successfully implement its sales and marketing
plan.

Dependence on Key Personnel

The Company is dependent on the efforts of its executive officers, scientists
and other key employees, the loss of any one of whom could have a materially
adverse effect on the Company's business. Shortages of qualified scientists
within certain disciplines may occur and competition for the services of
qualified scientists may intensify. The Company may not be successful in
recruiting or retaining such personnel in the future.

Government Regulation

-17-

addition, commercialization of the BDS technology outside the United States will
require compliance with the regulations of foreign countries. Failure to comply
with applicable regulations could have an adverse effect on the Company. See "--
Government Regulation."

Competition

The Company expects to encounter competition from suppliers of existing
desulfurization technology in the marketing of the Company's BDS units. These
companies have well-established relationships in the refining industry and have
substantially greater financial, technical and human resources than the Company.
In addition, new desulfurization technologies could be developed that are
competitive with or superior to the Company's BDS technology. See "--
Competition."

ITEM 2. PROPERTIES

FACILITIES

The Company's corporate offices and laboratories are situated in a 28,500
square-foot leased building located at 4200 Research Forest Drive in The
Woodlands, Texas, a suburb of Houston, Texas. Pursuant to the lease, monthly
payments of $30,440 are required for base rent. The lease for this facility
expires in 1998 and the Company has a renewal option extending the lease to
2003. Approximately 20,500 square feet of this space is devoted to research and
development. The facility includes two laboratories designed for molecular
biology/microbiology/microbial physiology, a process engineering laboratory, a
biochemistry laboratory, a media preparation laboratory, and an analytical
laboratory which provides all the routine sulfur and hydrocarbon analyses for
the operation. In March 1995 the Company completed construction of a
fermentation laboratory, microbiology laboratory and accelerated development
program laboratories.

See "Item 1. Business - Patents and Proprietary Technology" for a description
of the Company's patents.

ITEM 3. LEGAL PROCEEDINGS.

There are no material pending legal proceedings required to be reported in
response to this item.

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

No matters were submitted to a vote of the Company's security holders during
the last quarter of the fiscal year ended December 31, 1996.

-18-

PART II.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS.

The Company's common stock (symbol: ENBC) is traded on the Nasdaq National
Market. The following table sets forth the range of high and low sales prices
for each calendar quarterly period in the two years ended December 31, 1996 as
reported on the Nasdaq National Market:

YEAR ENDED DECEMBER 31, 1996 High Low
- ---------------------------- ------ -----

First Quarter.............................. $ 8.75 $5.25
Second Quarter............................. 9.50 5.50
Third Quarter.............................. 8.63 4.38
Fourth Quarter............................. 7.50 4.88
YEAR ENDED DECEMBER 31, 1995 High Low
- ---------------------------- ------ -----
First Quarter.............................. $ 6.25 $4.75
Second Quarter............................. 8.00 3.75
Third Quarter.............................. 10.00 4.00
Fourth Quarter............................. 9.75 7.00

As of March 14, 1997, 11,605,377 shares of common stock were outstanding and
the Company had approximately 105 shareholders of record.

DIVIDENDS

The Company has never paid cash dividends on its common stock. The Company
currently intends to retain any earnings to finance the growth and development
of its business and does not anticipate paying cash dividends in the foreseeable
future.

-19-

ITEM 6. SELECTED FINANCIAL DATA

The selected financial data set forth below with respect to the Company's
statements of operations for each of the five years in the period ended December
31, 1996 and with respect to the Company's balance sheets as of December 31,
1992, 1993, 1994, 1995 and 1996 are derived from the Financial Statements of the
Company that have been audited by Arthur Andersen LLP, independent public
accountants. The financial data should be read in conjunction with the
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and the Company's Financial Statements and Notes thereto included
elsewhere in this report.

YEAR ENDED DECEMBER 31,
-----------------------------------------------------------------------
1992 1993 1994 1995 1996
--------- ---------- ---------- ----------- -----------
STATEMENTS OF OPERATIONS DATA: (IN THOUSANDS, EXCEPT PER SHARE DATA)
-----------------------------------------------------------------------

Revenues:
Sponsored research revenues...................... $ 867 $ 1,134 $ 1,148 $ 1,567 $ 1,778
Interest and investment income................... 329 510 573 1,401 807
---------- ---------- ---------- ----------- -----------
Total revenues........................... 1,196 1,644 1,721 2,968 2,585
Costs and Expenses:
Research and development......................... 4,839 (1) 4,894 5,723 7,338 9,210
General and administrative....................... 3,162 (2) 2,037 2,978 2,877 2,608
---------- ---------- ---------- ----------- -----------
Total costs and expenses................. $ 8,001 $ 6,931 $ 8,701 $ 10,215 $ 11,818
---------- ---------- ---------- ----------- -----------
Net loss........................................... $ (6,805) $ (5,287) $ (6,980) $ (7,247) $ (9,233)
========== ========== ========== =========== ===========
Net loss per common share.......................... $ (0.96) $ (0.57) $ (0.75)(3) $ (0.95)(3) $ (1.04)(3)
========== ========== ========== =========== ===========
Shares used in computing net loss.................. 7,058,547 9,195,517 9,967,645 10,227,595 11,248,029
per common share................................. ========== ========== ========== =========== ===========

- ----------------
(1) Includes a non-cash charge of $432,655 for compensation expense related to
executive stock options issued prior to the Company's initial public
offering.
(2) Includes a non-cash charge of $2,250,135 for compensation expense related to
executive stock options issued prior to the Company's initial public
offering.
(3) Net loss per common share has been computed by dividing the net loss, which
has been increased for periodic accretion and dividends on the preferred
stock issued in October 1994, by the weighted average number of shares of
common stock outstanding during the period.

DECEMBER 31,
--------------------------------------------------------------
1992 1993 1994 1995 1996
------------- --------- -------------- --------- ---------
(in thousands)

BALANCE SHEET DATA:
Cash and cash equivalents................................. $ 3,496 $ 6,135 $ 28,284 $ 6,172 $ 3,106
Working capital........................................... 1,817 11,650 26,269 15,084 8,770
Total assets.............................................. 4,962 16,055 32,175 23,809 13,711
Long-term capital lease obligations....................... 44 32 21 11 --
Accumulated deficit....................................... (9,148) (14,501) (21,907) (31,321) (42,713)
Total stockholders' equity................................ 106 12,891 28,444 21,577 12,715

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

Overview

Since its inception in December 1989, the Company has devoted substantially
all of its resources to research and development. To date, all of the Company's
revenues have resulted from interest and investment income and sponsored
research payments from collaborative agreements. The Company has incurred
cumulative losses since inception and expects to incur substantial losses for at
least the next several years, due primarily to the increase in its research and
development activities and acceleration of the development of its biocatalyst,
fermentation and bioreactor programs.

-20-

The Company expects that losses will fluctuate from quarter to quarter and that
such fluctuations may be substantial. As of December 31, 1996, the Company's
accumulated deficit was $42,713,302.

Results of Operations

The Company had total revenues for the years ended December 31, 1994, 1995 and
1996 of $1,721,309, $2,967,954 and $2,585,419, respectively. Sponsored research
revenues increased by $14,000, $419,329 and $211,354 in 1994, 1995 and 1996,
respectively, primarily as a result of the Company's grant from the National
Institute of Standards and Technology in 1995 and 1996 and the Carbide/Graphite
agreement in 1996. Payments under the Petrolite agreement were initiated on
April 1, 1992 and totaled $5,400,000 through March 1994. Payments received from
Petrolite were $675,000 in 1994; no payments were received from Petrolite in
1995 or 1996. In each of the years ended December 31, 1994, 1995 and 1996,
$1,134,000 was recognized as revenue under the Petrolite agreement; as of
December 31, 1994, 1995 and 1996, the Company had balances of $2,461,500,
$1,147,500 and $13,500 respectively, of deferred revenues under the Petrolite
agreement. The amount recognized is based on the total payments received in
relation to the total research and development costs to be incurred under the
terms of the agreement. Interest and investment income increased by $63,231 and
$827,316 in 1994 and 1995, respectively, as a result of the increase in cash and
cash equivalents and related investments in marketable securities. In 1996,
interest and investment income decreased by $593,889 as a result of the decrease
in cash and cash equivalents and related investments in marketable securities.

The Company had research and development expenses for the years ended December
31, 1994, 1995 and 1996 of $5,723,131, $7,338,319 and $9,210,227, respectively.
The $1,615,188 increase from 1994 to 1995 resulted from the addition of 16
personnel in the research and development department and the completion of 4,500
square feet of additional laboratory space at the end of the first quarter of
1995. The increase of $1,871,908 from 1995 to 1996 resulted from the addition
of nine personnel in the research and development department, additional office
space acquired during the first quarter of 1996 for research personnel and a
$1,000,000 option payment to Petrolite. The Company expects its research and
development expenses to decrease during 1997, reflecting the nonrecurring
payment to Petrolite in 1996 of $1,000,000, offset in part by a slight increase
in expenditures related to hiring additional personnel. The Company's research
and development expenses will increase substantially, however, if the Company
makes the $9,000,000 payment to exercise the Petrolite option in 1997, the
entire amount of which will be recorded as a research and development expense.
The Company does not presently intend to exercise the Petrolite option until it
has raised additional funds or received additional capital.

The Company had general and administrative expenses for the years ended
December 31, 1994, 1995 and 1996 of $2,977,679, $2,877,351 and $2,607,972,
respectively. The $100,328 decrease from 1994 to 1995 resulted primarily from
the reassignment of a vice president to responsibilities within the research and
development department offset in part by increased expenditures for consulting
related to the stock rights plan instituted in 1995. The $269,379 decrease from
1995 to 1996 resulted primarily from decreased consulting fees, legal fees and
insurance. The Company expects its general and administrative expenses to
increase slightly in 1997 in support of its research facilities and personnel,
and corporate development activities.

Liquidity and Capital Resources

In February 1997, the Company completed a convertible preferred stock offering
resulting in net cash proceeds of approximately $10.2 million in exchange for
the sale of 224,100 shares of Series B Convertible Preferred Stock. In October
1994, the Company completed a convertible preferred stock offering resulting in
net cash proceeds of approximately $22.2 million in exchange for the sale of
480,000 shares of Series A Convertible Preferred Stock. The Company completed
its initial public offering in the first quarter of 1993, resulting in net cash
proceeds of approximately $14.9 million.

For the year ended December 31, 1996, the Company used $4,787,699 of funds in
operating activities, and incurred $936,877 of capital expenditures. At
December 31, 1996, the Company had cash, cash equivalents, and short term
investments totaling $8,997,588 and working capital of $8,770,324.

-21-

The Company expects to incur substantial additional research and development
expenses, including expenses associated with biocatalyst, fermentation and
bioreactor development. The Company has commitments through 1997 requiring the
Company to spend approximately $95,000 under research and development
agreements. In addition, the Company is subject to cost sharing arrangements
under various collaborative agreements, as discussed below. The Company also
expects its general and administrative expenses to increase as it adds
marketing, sales and other personnel and prepares for the commercialization of
the Company's proprietary BDS technology.

To supplement its research and development budgets, the Company intends to
seek additional collaborative research and development agreements with corporate
partners. In this regard, the Company entered into an agreement with
Carbide/Graphite in December 1995 to collaborate on the development of the
Company's BDS technology for the removal of sulfur from decant oil. Under the
terms of the agreement, the Company will be primarily responsible for
customizing and commercializing a biocatalyst and desulfurization system
specifically for decant oil. Carbide/Graphite will be primarily responsible for
providing the development and commercialization funding for this particular BDS
process.

The Company signed an agreement with M.W. Kellogg in August 1994, to
collaborate on the development and commercialization of the Company's
proprietary biocatalytic desulfurization technology for reducing sulfur levels
in petroleum streams. Under the terms of the collaboration, M.W. Kellogg will
serve as an engineering partner to the Company during completion of the BDS
development process and will be the exclusive provider of the basic engineering
design services required for the commercial BDS units. In return for these
services, M.W. Kellogg will receive a portion of the site license fee generated
by the sale of BDS units. The collaboration has a minimum term of at least five
years or the completion of 20 BDS units, whichever is longer, and has
applications to all biorefining technologies the Company develops. During the
first phase of the collaboration, M.W. Kellogg provided 500 engineering work
hours of service at no cost to the Company. M.W. Kellogg has agreed to provide
an additional 1,500 work hours of service at M.W. Kellogg offices at reduced
rates, of which 500 had been utilized by the Company at December 31, 1996.

In July 1994, the Company entered into an Agreement with Total to collaborate
on the application of the Company's biodesulfurization process to diesel fuel
streams. Following the evaluation of results from Energy BioSystems' domestic
pilot operation, it is anticipated that Total will build and operate at Total's
expense a pilot BDS unit at Total's European Centre for Research and Technology.
Upon successful economic trials of the pilot unit, Total plans to build the
first commercial BDS unit at one of its refineries.

In December 1993, the Company entered into a research collaboration agreement
with Koch, to facilitate the development of BDS technology in refinery petroleum
streams. Under the terms of the alliance, the Company will be primarily
responsible for improving the performance of the biocatalyst used in the
desulfurization process. Koch will be primarily responsible for selecting and
improving the target refinery stream as well as testing desulfurized product
quality. Koch will also provide engineering support as needed in the
development of a BDS unit for Koch's operation. The Company and Koch will each
bear their own costs and expenses incurred in connection with the collaboration.
The Company expects that the development alliance with Koch will facilitate
commercialization of the Company's BDS technology.

In October 1993, the Company amended its existing Collaboration Agreement with
Petrolite. The Collaboration Agreement, as amended (the "Agreement"), provides
for an expanded territory covered by the Agreement and permits the use of third
party engineering and construction companies to assist with certain matters.
The Agreement expands the territory of Petrolite's participation from North
America, Venezuela and Mexico to the entire world. In return for the expansion
of the territory covered by the Agreement, the Company's primary participation
rate was increased from 70% of gross profits from biodesulfurization unit sales
and fees to 78% of worldwide gross profits from such sales and fees.
Additionally, the Agreement allows the Company, after obtaining the advice and
input of Petrolite, to enter into an alliance with one or more world-class third
party engineering and construction firms to provide certain equipment and
services in connection with the design and construction of biodesulfurization
units.

-22-

In October 1996, the Company entered into an agreement with Petrolite
providing the Company with the option to amend the terms of its strategic
alliance with Petrolite. Under the agreement, the Company made an initial
payment of $1 million to Petrolite in December 1996 in exchange for the option
and the extension of Petrolite's obligations to provide operational and
technical support for the pilot plant from September 1, 1996 through December
31, 1998. If the Company exercises its option, the percentage of site license
fees and adjusted gross profit payable to Petrolite will be reduced to 9.5% from
22%, in exchange for which the Company will (i) assume responsibility for
servicing the BDS units on site at customer locations, (ii) pay Petrolite an
additional $9 million in cash and (iii) issue to Petrolite a warrant entitling
Petrolite to purchase 138,889 shares of Common Stock at an exercise price of
$7.20 per share. The Company may exercise the Petrolite option at any time on
or before the earlier to occur of (i) ten business days following the close of
any equity financing by the Company in which the gross cash proceeds raised in
such financing (together with cash proceeds raised by the Company in any other
equity financing after the date of the option agreement, if applicable) equal or
exceed $25 million and (ii) December 30, 1998.

In July 1993, the Company entered into a research collaboration agreement with
Texaco to facilitate the development of the Company's BDS technology in crude
oil. Under the terms of the alliance, the Company will be primarily responsible
for improving the performance of the biocatalyst used in the desulfurization
process. Texaco will be primarily responsible for field operations and
analytical chemistry work with respect to the application of the Company's BDS
technology to crude oil. The Company and Texaco will each bear their own costs
and expenses incurred in connection with the collaboration. The Company expects
that the development alliance with Texaco will facilitate commercialization of
the Company's BDS technology.

The Company entered into a license agreement with Stanford University in
November 1993 for the use of its patented recombinant DNA technology which may
be employed in the development of the Company's biocatalytic desulfurization
process. The license requires a minimum annual advance on earned royalties of
$10,000.

The Company believes that its available cash, investments and interest income
will be adequate to satisfy its funding needs through year-end 1998. The
Company's future funding requirements will depend on many factors, including the
progress of the Company's research and development, timing of environmental
regulations, the rate of technological advances, determinations as to the
commercial potential of the Company's technology under development, the status
of competitive technology, the establishment of biocatalyst manufacturing
capacity or third-party manufacturing arrangements and the establishment of
other collaborative relationships. The Company may seek additional funding
through public or private financings, including equity financings, and through
collaborative arrangements.

ITEM 8. FINANCIAL STATEMENTS.

The financial statements required by this Item are incorporated under Item 14
in Part IV of this report.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.

None.

-23-

PART III.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

The information required by this Item as to the directors and executive
officers of the Company is hereby incorporated by reference from the information
appearing under the captions "Election of Directors" and "Executive Officers" in
the Company's definitive proxy statement which involves the election of
directors and is to be filed with the Securities and Exchange Commission
("Commission") pursuant to the Securities Exchange Act of 1934 within 120 days
of the end of the Company's fiscal year on December 31, 1996.

ITEM 11. EXECUTIVE COMPENSATION.

The information required by this Item as to the management of the Company is
hereby incorporated by reference from the information appearing under the
captions "Executive Compensation" and "Election of Directors - Director
Compensation" in the Company's definitive proxy statement which involves the
election of directors and is to be filed with the Commission pursuant to the
Securities Exchange Act of 1934 within 120 days of the end of the Company's
fiscal year on December 31, 1996. Notwithstanding the foregoing, in accordance
with the instructions to Item 402 of Regulation S-K, the information contained
in the Company's proxy statement under the sub-heading "Report of the
Compensation Committee of the Board of Directors" and "Performance Graph" shall
not be deemed to be filed as part of or incorporated by reference into this Form
10-K.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

The information required by this Item as to the ownership by management and
others of securities of the Company is hereby incorporated by reference from the
information appearing under the caption "Security Ownership of Certain
Beneficial Owners and Management" to the Company's definitive proxy statement
which involves the election of directors and is to be filed with the Commission
pursuant to the Securities Exchange Act of 1934 within 120 days of the end of
the Company's fiscal year on December 31, 1996.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

The information required by this Item as to certain business relationships and
transactions with management and other related parties of the company is hereby
incorporated by reference to such information appearing under the captions
"Certain Transactions" and "Compensation Committee Interlocks and Insider
Participation" in the Company's definitive proxy statement which involves the
election of directors and is to be filed with the Commission pursuant to the
Securities Exchange Act of 1934 within 120 days of the end of the Company's
fiscal year on December 31, 1996.

-24-

PART IV.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.

(a) Documents Filed as a Part of this Report

1. FINANCIAL STATEMENTS:

PAGE
----
Report of Independent Public Accountants...................... F-1
Balance Sheets as of December 31, 1995 and 1996............... F-2
Statements of Operations for the Years Ended
December 31, 1994, 1995 and 1996............................. F-3
Statements of Stockholders' Equity for the Period
from December 31, 1993 to December 31, 1996.................. F-4
Statements of Cash Flows for the Years Ended
December 31, 1994, 1995 and 1996............................. F-5
Notes to Financial Statements................................. F-6

All other schedules are omitted because they are not applicable, not required,
or because the required information is included in the financial statements or
notes thereto.

2. EXHIBITS:

Exhibits to the Form 10-K have been included only with the copies of the Form
10-K filed with the Commission and the Nasdaq Stock Market. Upon request to the
Company and payment of a reasonable fee, copies of the individual exhibits will
be furnished.

EXHIBIT NO. DESCRIPTION
- ----------- -----------

3.1(a) Amended and Restated Certificate of Incorporation of Registrant
(incorporated by reference to Exhibit 2 filed with Post-Effective
Amendment No. 1 to the Registrant's Registration Statement on Form
8-A as filed with the Commission on March 15, 1993).

3.1(b) Certificate of the Powers, Designations, Preferences and Rights of
the Series A Convertible Preferred Stock (incorporated by reference
to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for
the quarter ended September 30, 1994).

3.1(c) Certificate of Designation of Series One Junior Participating
Preferred Stock of the Company (incorporated by reference to
Exhibit 3.1(c) to the Company's Annual Report on Form 10-K for the
year ended December 31, 1994).

*3.1(d) Certificate of the Powers, Designation, Preferences and Rights of
the Series B Convertible Preferred Stock.

3.2 Bylaws of Registrant (incorporated by reference to Exhibit 3 filed
with Post-Effective Amendment No. 1 to the Registrant's
Registration Statement on Form 8-A as filed with the Commission on
March 15, 1993).

4.1 Form of Stock Purchase Agreement, dated as of October 27, 1994, by
and between the Company and the Purchasers of the Series A
Convertible Preferred Stock (incorporated by reference to Exhibit
10.1 to the Company's Quarterly Report on Form 10-Q for the quarter
ended September 30, 1994).

-25-

EXHIBIT NO. DESCRIPTION
- ----------- -----------

*4.2 Form of Stock Purchase Agreement, dated as of February 21, 1997, by
and between the Company and the Purchasers of the Series B
Convertible Preferred Stock.

*4.3 Form of Stock Exchange Agreement, dated as of February 21, 1997, by
and between the Company and the Exchanging Holders of Series A
Convertible Preferred Stock.

4.4 Stockholder Rights Agreement, dated as of March 8, 1995, between
the Company and Society National Bank (incorporated by reference to
Exhibit 4.1 to the Company's Current Report on Form 8-K dated March
8, 1995).

10.1 License and Technology Assistance Agreement, dated January 15,
1991, between the Company and Institute of Gas Technology ("IGT")
(incorporated by reference to the similarly numbered exhibit to the
Company's Registration Statement on Form S-1 (No. 33-56718)).

10.2 First Amendment to License and Technology Assistance Agreement,
dated June 25, 1992, between the Company and IGT (incorporated by
reference to the similarly numbered exhibit to the Company's
Registration Statement on Form S-1 (No. 33-56718)).

10.3 Agreement, dated August 27, 1992, among the Company, IGT, the
University of North Dakota ("UND") and Dr. Kevin Young
(incorporated by reference to the similarly numbered exhibit to the
Company's Registration Statement on Form S-1 (No. 33-56718)).

10.4 Agreement, dated September 30, 1992, among the Company, UND and Dr.
Kevin Young (incorporated by reference to the similarly numbered
exhibit to the Company's Registration Statement on Form S-1
(No. 33-56718)).

10.5 Collaboration Agreement, dated March 5, 1992, between the Company
and Petrolite Corporation (incorporated by reference to the
similarly numbered exhibit to the Company's Registration Statement
on Form S-1 (No. 33-56718)).

10.6 Lease Agreement, dated January 24, 1994, between The Woodlands
Corporation and the Company (incorporated by reference to Exhibit
10.6 to the Company's Annual Report on Form 10-K for the fiscal
year ended December 31, 1993).

10.7 Registration Agreement, dated January 30, 1992, among the Company,
The Travelers Indemnity Company and Gryphon Ventures II, Limited
Partnership (incorporated by reference to the similarly numbered
exhibit to the Company's Registration Statement on Form S-1
(No. 33-56718)).

10.8 Registration Agreement, dated April 29, 1991, between the Company
and Gryphon Ventures II, Limited Partnership (incorporated by
reference to the similarly numbered exhibit to the Company's
Registration Statement on Form S-1 (No. 33-56718)).

10.9** Energy BioSystems Corporation 1992 Stock Compensation Plan
(incorporated by reference to Exhibit 10.10 to the Company's
Registration Statement on Form S-1 (No. 33-56718)).

*10.10** Employment Agreement, dated January 31, 1996, between the Company
and Daniel J. Monticello.

10.11** Consultant Agreement between the Company and John T. Preston
(incorporated by reference to Exhibit 10.12 to the Company's
Registration Statement on Form S-1 (No. 33-56718)).

10.12** Employment Agreement, dated August 21, 1991, between the Company
and John H. Webb (incorporated by reference to Exhibit 10.13 to the
Company's Registration Statement on Form S-1 (No. 33-56718)).

-26-

EXHIBIT NO. DESCRIPTION
- ----------- -----------

10.13** Amendment No. 1 to Employment Agreement, dated as of January 15,
1996, between the Company and John H. Webb (incorporated by
reference to Exhibit 10.35 to the Company's Annual Report on Form
10-K for the year ended December 31, 1995).

10.14** Employment Agreement, dated July 18, 1995, between the Company and
Paul G. Brown, III (incorporated by reference to the similarly
numbered exhibit to the Company's Registration Statement on Form
S-1 (No. 33-96096)).

10.15** Employment Agreement, dated July 18, 1995, between the Company and
Mark W. John (incorporated by reference to the similarly numbered
exhibit to the Company's Registration Statement on Form S-1
(No. 33-96096)).

10.16** Employment Agreement, dated July 18, 1995, between the Company and
Robert E. Levy (incorporated by reference to the similarly numbered
exhibit to the Company's Registration Statement on Form S-1
(No. 33-96096)).

10.17** Amended and Restated Consultant Agreement between the Company and
William M. Haney, III (incorporated by reference to the Exhibit
10.14 to the Company's Registration Statement on Form S-1 (No. 33-
56718)).

10.18** Simplified Employee Pension Plan Retirement Plan Adoption Agreement
(incorporated by reference to Exhibit 10.15 to the Company's
Registration Statement on Form S-1 (No. 33-56718)).

10.19** Energy BioSystems Corporation Non-Employee Director Option Plan
(incorporated by reference to the similarly numbered exhibit to the
Company's Registration Statement on Form S-1 (No. 33-96096)).

10.20 First Amendment to Collaboration Agreement, dated July 1, 1992,
between the Company and Petrolite Corporation (incorporated by
reference to the Exhibit 10.16 to the Company's Registration
Statement on Form S-1 (No. 33-56718)).

10.21 Research Agreement, dated November 8, 1993, between the Company and
The University of Notre Dame (incorporated by reference to Exhibit
10.19 to the Company's Registration Statement on Form S-1 (No. 33-
56718)).

10.22 Research Collaboration Agreement, dated July 8, 1993, between the
Company and Texaco, Inc. (incorporated by reference to Exhibit 99.1
to the Company's Quarterly Report on Form 10-Q for the quarter
ended June 30, 1993).

10.23 Extension and Assignment of Research Collaboration Agreement, dated
June 23, 1995, between the Company and Texaco Inc. (incorporated by
reference to the similarly numbered exhibits to the Company's
Registration Statement on Form S-1 (No. 3-96096)).

10.24 Second Amendment to Collaboration Agreement, dated October 18,
1993, between the Company and Petrolite Corporation (incorporated
by reference to Exhibit 99.1 to the Company's Quarterly Report on
Form 10-Q for the quarter ended September 30, 1993).

10.25 Lease Agreement, dated May 24, 1993, between the Company and The
Woodlands Corporation (incorporated by reference to Exhibit 99.2 to
the Company's Quarterly Report on Form 10-Q for the quarter ended
September 30, 1993).

10.26 Second Amendment to License and Technology Assistance Agreement,
dated September 23, 1993, between the Company and IGT (incorporated
by reference to Exhibit 10.21 to the Company's Annual Report on
Form 10-K for the fiscal year ended December 31, 1993).

-27-

EXHIBIT NO. DESCRIPTION
- ----------- -----------

10.27 Letter Agreement dated February 10, 1994, between The M. W. Kellogg
Company and the Company (incorporated by reference to Exhibit 10.22
to the Company's Annual Report on Form 10-K for the fiscal year
ended December 31, 1993).

10.28 Letter Agreement for Accelerated Development Program dated December
8, 1993, between the Company and Koch Refining Company
(incorporated by reference to Exhibit 10.23 to the Company's Annual
Report on Form 10-K for the fiscal year ended December 31, 1993).

10.29 License Agreement dated November 1, 1993, between the Company and
Stanford University (incorporated by reference to Exhibit 10.25 to
the Company's Annual Report on Form 10-K for the fiscal year ended
December 31, 1993).

10.30 Collaboration Agreement dated July 7, 1994, between the Company and
Total Raffinage Distribution S.A. (incorporated by reference to
Exhibit 99.1 to the Company's Quarterly Report on Form 10-Q for the
second quarter ended June 30, 1994).

10.31 Research Agreement, dated July 1, 1994, between the Company and
Massachusetts Institute of Technology (incorporated by reference to
Exhibit 10.27 to the Company's Annual Report on Form 10-K for the
year ended December 31, 1994).

10.32 Research Agreement, dated November 8, 1994, between the Company and
The University of Notre Dame (incorporated by reference to Exhibit
10.28 to the Company's Annual Report on Form 10-K for the year
ended December 31, 1994).

10.33 Research, Option and License Agreement, dated December 15, 1994,
between the Company and the University of Houston (incorporated by
reference to Exhibit 10.29 to the Company's Annual Report on Form
10-K for the year ended December 31, 1994).

10.34 Cooperative Agreement between the Company and the National
Institute of Standards and Technology (incorporated by reference to
Exhibit 10.30 to the Company's Annual Report on Form 10-K for the
year ended December 31, 1994).

10.35 Extension and Assignment of Research Collaboration Agreement, dated
July 3, 1996, between the Company and Texaco Group, Inc.
(incorporated by reference to Exhibit 10.1 to the Company's
Quarterly Report on Form 10-Q for the quarter ended June 30, 1996).

*10.36 Third Amendment and Addendum to Collaboration Agreement, dated
August 24, 1995, between the Company and Petrolite Corporation.

*10.37 Fourth Amendment and Addendum to Collaboration Agreement, dated
October 25, 1996, between the Company and Petrolite Corporation, as
modified by Letter Agreement dated December 30, 1996.

*11.1 Computation of earnings per share.

*23.1 Consent of Arthur Andersen LLP.

- ----------------
* Filed herewith
** Management contract or compensatory plan.

(b) Reports on Form 8-K

The Company filed one report on Form 8-K during the last quarter of the
year ended December 31, 1996. Such report on Form 10-K, dated November 20,
1996, enclosed a copy of a press release announcing the commencement of

-28-

a private offering of Series B Convertible Preferred Stock, and was filed
pursuant to Rule 135c under the Securities Act of 1933, as amended.

-29-

SIGNATURES

PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934, THE COMPANY HAS DULY CAUSED THIS REPORT TO BE SIGNED ON
ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED.

Energy BioSystems Corporation

By: /s/ John H. Webb
---------------------------------------
John H. Webb
Chairman of the Board,
President and Chief Executive Officer

DATED the 20th day of March, 1997.

PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS
REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE COMPANY
AND IN THE CAPACITIES AND ON THE DATES INDICATED:

NAME TITLE DATE
---- ----- ----

/s/ JOHN H. WEBB Chairman of the Board, President March 20, 1997
- ----------------------------- and Chief Executive Officer
John H. Webb (Principal executive officer)

/s/ PAUL G. BROWN, III Vice President--Finance and March 20, 1997
- ----------------------------- Administration (Principal
Paul G. Brown, III financial and accounting
officer)

/s/ DANIEL J. MONTICELLO, PH.D. Vice President--Science and March 20, 1997
- ------------------------------ Technology, and Director
Daniel J. Monticello, Ph.D.

/s/ BERNARD LEE, PH.D. Director March 20, 1997
- -----------------------------
Bernard Lee, Ph.D.

/s/ RAMON LOPEZ Director March 20, 1997
- -----------------------------
Ramon Lopez

/s/ EDWARD B. LURIER Director March 20, 1997
- -----------------------------
Edward B. Lurier

/s/ THOMAS E. MESSMORE Director March 20, 1997
- -----------------------------
Thomas E. Messmore

/s/ WILLIAM E. NASSER Director March 20, 1997
- -----------------------------
William E. Nasser

/s/ JOHN S. PATTON Director March 20, 1997
- -----------------------------
John S. Patton

/s/ JOHN T. PRESTON Director March 20, 1997
- -----------------------------
John T. Preston

/s/ WILLIAM D. YOUNG Director March 20, 1997
- -----------------------------
William D. Young

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To Energy BioSystems Corporation:

We have audited the accompanying balance sheets of Energy BioSystems
Corporation (a Delaware corporation) as of December 31, 1995 and 1996, and the
related statements of operations, stockholders' equity and cash flows for each
of the three years in the period ended December 31, 1996. 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 generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. 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 audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Energy BioSystems Corporation
as of December 31, 1995 and 1996, and the results of its operations and its cash
flows for each of the three years in the period ended December 31, 1996 in
conformity with generally accepted accounting principles.

ARTHUR ANDERSEN LLP

The Woodlands, Texas
March 7, 1997

F-1

ENERGY BIOSYSTEMS CORPORATION

BALANCE SHEETS

December 31,
----------------------------
1995 1996
------------- -------------

ASSETS

Current assets:
Cash and cash equivalents............. $ 6,172,400 $ 3,106,004
Short term investments................ 10,431,444 5,891,584
Prepaid expenses and other current.... 687,530 767,893
assets............................... ------------ ------------
Total current assets.......... $ 17,291,374 $ 9,765,481
------------ ------------

Long term investments................... 2,492,874 --
Note receivable......................... 45,633 6,683
Furniture, equipment and leasehold
improvements, net...................... 3,322,609 3,136,635
Intangible and other assets, net........ 656,961 801,832
------------ ------------
Total assets.................. $ 23,809,451 $ 13,710,631
============ ============

LIABILITIES & STOCKHOLDERS' EQUITY

Current liabilities:
Accounts payable and accrued
liabilities.......................... $ 591,534 $ 537,583
Current portion of deferred revenue... 1,314,000 193,500
Current portion of obligations under
capital lease........................ 7,256 11,632
Note payable.......................... 294,713 252,443
------------ ------------
Total current liabilities..... $ 2,207,503 $ 995,158
------------ ------------

Long term liabilities:
Capital lease obligations............. 11,632 --
Deferred revenue...................... 13,500 --
------------ ------------
Total long term liabilities... $ 25,132 --
------------ ------------

Stockholders' equity:
Series A convertible preferred stock.... 22,968,152 23,295,585
$0.01 par value (liquidation value
$24,000,000,
508,800 shares authorized, 480,000
shares
issued and outstanding)
Common stock, $0.01 par value
(30,000,000 shares authorized, 10,584,269
and 11,497,135 shares issued and outstanding,
respectively)......................... 105,843 114,972
Additional paid-in capital.............. 29,823,343 32,018,218
Accumulated deficit..................... (31,320,522) (42,713,302)
------------ ------------
Total stockholders' equity.... $ 21,576,816 $ 12,715,473
------------ ------------
Total liabilities and......... $ 23,809,451 $ 13,710,631
stockholders' equity......... ============ ============

The accompanying notes are an integral part of these financial statements.

F-2

ENERGY BIOSYSTEMS CORPORATION

STATEMENTS OF OPERATIONS

Year Ended December 31,
---------------------------------------------
1994 1995 1996
--------------- ------------- -------------

REVENUES:
Sponsored research revenues................. $ 1,148,000 $ 1,567,329 $ 1,778,683
Interest and investment income.............. 573,309 1,400,625 806,736
----------- ----------- -----------
Total revenues...................... 1,721,309 2,967,954 2,585,419
----------- ----------- -----------
COSTS AND EXPENSES:
Research and development.................... 5,723,131 7,338,319 9,210,227
General and administrative.................. 2,977,679 2,877,351 2,607,972
----------- ----------- -----------
Total costs and expenses............ 8,700,810 10,215,670 11,818,199
----------- ----------- -----------
NET LOSS...................................... $(6,979,501) $(7,247,716) $(9,232,780)
=========== =========== ===========
NET LOSS PER COMMON SHARE..................... $(0.75) $(0.95) $(1.04)
=========== =========== ===========
SHARES USED IN COMPUTING NET LOSS
PER COMMON SHARE........................... 9,967,645 10,227,595 11,248,029
=========== =========== ===========

The accompanying notes are an integral part of these financial statements.

F-3

ENERGY BIOSYSTEMS CORPORATION

STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE PERIOD FROM DECEMBER 31, 1993 TO DECEMBER 31, 1996

Preferred Stock Common Stock Additional
--------------- ------------ Paid-in Accumulated
Shares Amount Shares Amount Capital Deficit Total
-------- -------- --------- -------- ----------- ------------ -------

BALANCE AT DECEMBER 31, 1993 -- $ -- 9,864,629 $ 98,646 $27,293,378 $(14,501,305) $12,890,719
Exercise of stock options
in 1994 ($0.3036 to $4.80
per share)................... -- -- 123,780 1,238 310,177 -- 311,415
Issuance of Series A
Convertible
Preferred Stock for cash at
October 27, 1994 ($50.00
per share), net of
$1,778,403 offering costs.... 480,000 22,221,597 -- -- -- -- 22,221,597
Accretion and dividends on
Series A Preferred Stock..... -- 473,334 -- -- (47,334) (426,000) --
Net loss...................... (6,979,501) (6,979,501)
-------- ----------- ---------- -------- ----------- ------------ -----------
BALANCE AT DECEMBER 31, 1994 480,000 22,694,931 9,988,409 99,884 27,556,221 (21,906,806) 28,444,230
Exercise of stock options in
1995 ($0.3036 to $7.25 per
share)....................... -- -- 261,949 2,620 329,392 -- 332,012
Issuance of stock for services
($6.25 per share)............ -- -- 10,000 100 62,400 -- 62,500
Additional offering costs for
Series A Preferred Stock..... -- (14,132) -- -- -- -- (14,132)
Dividends on Series A
Preferred Stock paid in
Common Stock................. -- (2,178,000) 323,910 3,239 2,174,683 -- (78)
Accretion and dividends on
Series A Preferred Stock..... 2,465,353 -- -- (299,353) (2,166,000) --
Net loss...................... -- -- -- -- -- (7,247,716) (7,247,716)
-------- ----------- ---------- -------- ----------- ------------ -----------
BALANCE AT DECEMBER 31, 1995 480,000 22,968,152 10,584,268 105,843 29,823,343 (31,320,522) 21,576,816
Exercise of stock options
in 1996 ($0.3036 to $5.50
per share)................... -- -- 589,200 5,892 365,620 -- 371,512
Dividends on Series A
Preferred Stock paid in
Common Stock................. -- (2,160,000) 323,667 3,237 2,156,688 -- (75)
Accretion and dividends on
Series A Preferred Stock..... -- 2,487,433 -- -- (327,433) (2,160,000) --
Net loss...................... -- -- -- -- -- (9,232,780) (9,232,780)
-------- ----------- ---------- -------- ----------- ------------ -----------
BALANCE AT DECEMBER 31, 1996 480,000 $23,295,585 11,497,135 $114,972 $32,018,218 $(42,713,302) $12,715,473
======== =========== ========== ======== =========== ============ ===========

The accompanying notes are an integral part of these financial statements.

F-4

ENERGY BIOSYSTEMS CORPORATION

STATEMENTS OF CASH FLOWS

Year Ended December 31,
---------------------------------------------------------------
1994 1995 1996
---------------------- ------------------- ------------------

CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $(6,979,501) $ (7,247,716) $(9,232,780)
Adjustments to reconcile net loss to
net cash provided by (used in)
operating activities:
Depreciation and amortization............ 676,873 998,384 1,160,179
Compensation expense related to stock
options and stock issued for services
rendered............................... 48,000 62,500 --
Loss on sale of leasehold improvements... -- -- --
Changes in assets and liabilities:
Decrease (increase) in trading
securities............................. 6,754,863 (4,419,020) 4,444,020
Decrease in prepaid expenses and
other current assets................... 301,153 143,061 172,079
Decrease in notes receivable............. 32,896 37,054 38,950
Increase in intangible and other assets.. (148,690) (211,804) (182,196)
Decrease in accounts payable and
accrued liabilities.................... 295,127 (377,958) (53,951)
Decrease in deferred revenue............. (279,000) (1,134,000) (1,134,000)
----------- ------------ -----------
Net cash (used in) provided by operating
activities................................ 701,721 (12,149,499) (4,787,699)
----------- ------------ -----------

CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures........................ (1,025,980) (1,505,045) (936,877)
Net purchase of investments held to
maturity.................................. -- (8,480,298) 2,588,713
----------- ------------ -----------
Net cash (used in) investing activities (1,025,980) (9,985,343) 1,651,836
----------- ------------ -----------

CASH FLOWS FROM FINANCING ACTIVITIES:
Payments on notes payable................... -- (281,374) (294,713)
Payments on capital lease obligations....... (12,007) (12,995) (7,256)
Proceeds from Series A Preferred Stock, net. 22,221,597 (14,132) --
Proceeds from Common Stock, net............. 263,415 331,934 371,436
----------- ------------ -----------
Net cash provided by financing
activities............................... 22,473,005 23,433 69,467
----------- ------------ -----------

NET INCREASE (DECREASE) IN CASH AND
CASH EQUIVALENTS............................ 22,148,746 (22,111,409) (3,066,396)
----------- ------------ -----------

CASH AND CASH EQUIVALENTS AT BEGINNING
OF YEAR..................................... 6,135,063 28,283,809 6,172,400
----------- ------------ -----------
CASH AND CASH EQUIVALENTS AT END OF YEAR..... $28,283,809 $ 6,172,400 $ 3,106,004
=========== ============ ===========

SUPPLEMENTAL INFORMATION OF CASH FLOWS:
Cash paid for interest....................... $ 4,078 $ 4,010 $ 2,046
=========== ============ ===========

SUPPLEMENTAL INFORMATION OF NONCASH FINANCING ACTIVITIES:
The Company had an outstanding note payable of $281,374, $294,713 and $252,442 for prepaid insurance for the
years ended December 31, 1994, 1995 and 1996, respectively.

The accompanying notes are an integral part of these financial statements.

F-5

ENERGY BIOSYSTEMS CORPORATION

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1996

1. DESCRIPTION OF THE COMPANY

Energy BioSystems Corporation (the "Company"), formerly Environmental
BioScience Corporation, was incorporated in the State of Delaware on December
20, 1989, and commenced operations in January 1990. The Company was formed to
develop and commercialize innovative biotechnology-based processes for the
refining of fossil fuels. The Company's focus to date has been on developing
biocatalytic desulfurization ("BDS"), a proprietary process involving the use of
enzymes to remove sulfur from petroleum. The Company's BDS process will require
substantial additional research, development and testing in order to determine
its commercial viability. The Company has not proven its BDS technology other
than to a limited extent in laboratory, bench-scale and pilot plant trials. If
the Company successfully field tests its BDS technology, the commercialization
of the Company's BDS technology will require significant additional time and
expenditures. The commercialization of the technology will depend on the
Company's success in achieving improvement of its biocatalyst and success in
developing fermentation processes, as well as the Company's ability to
manufacture or contract for the manufacture of sufficient biocatalyst for use in
commercial BDS units; to apply process engineering to design bioreactor systems
capable of accomplishing the BDS process on a commercial scale; and to market
its BDS systems effectively. The accomplishment of some or all of these
objectives may be delayed or may never occur. The Company may require additional
capital to continue the development and commercialization of its BDS technology,
and there can be no assurance that such capital will be available or that the
Company will be able to successfully commercialize BDS technology. The Company
believes that its available cash and cash equivalents, investments and interest
income will be adequate to satisfy its funding needs through year-end 1998. See
"Liquidity and Capital Resources" and "Risk Factors" included elsewhere herein.

The Company has devoted substantially all of its efforts to research and
development. There have been no revenues from operations other than sponsored
research revenues (see Note 7) and there is no assurance of future revenues.
Prior to the receipt of the sponsored research revenues, the Company was in the
development stage.

2. ACCOUNTING POLICIES

Cash, Cash Equivalents and Short Term Investments

Debt and equity securities that the Company has the intent and ability to
hold to maturity are classified as "held to maturity" and reported at amortized
cost. Debt and equity securities that are held for current resale are classified
as "trading securities" and reported at fair value with unrealized gains and
losses included in earnings. Debt and equity securities not classified as either
"held to maturity" or "trading securities" are classified as "securities
available for sale" and reported at fair value, with unrealized gains and losses
excluded from earnings and reported as a separate component of stockholders'
equity.

Cash and cash equivalents include corporate debt securities with an
original maturity less than 90 days and are classified as held to maturity.
These securities have an amortized cost and fair market value of $245,000.
Included in short-term investments are U.S. government obligations and discount
commercial paper of $5,891,584 that are classified as held to maturity and
reported at amortized cost at December 31, 1996.

At December 31, 1995 and 1996, the Company had cash and cash equivalents of
approximately $257,284 and $49,684, respectively, in excess of the federally
insured amounts.

F-6

ENERGY BIOSYSTEMS CORPORATION

NOTES TO FINANCIAL STATEMENTS-(CONTINUED)

Furniture, Equipment and Leasehold Improvements

Furniture and equipment consists of office furniture and equipment,
computers and laboratory equipment and is carried at cost. Depreciation is
calculated on the straight-line method using a five-year estimated useful life.
Leasehold improvements are amortized on the straight-line method over the term
of the lease or the useful life of the assets, whichever is shorter.

Maintenance and repairs that do not improve or extend the life of assets
and expenditures for research and development equipment for which there is no
future alternative use are expressed as incurred. Expenditures which improve or
extend the life of assets are capitalized.

Intangible and Other Assets

Intangible and other assets mainly consist of patent costs, which are
primarily legal fees. These costs are being amortized over 17 years. Accumulated
amortization at December 31, 1995 and 1996 amounted to $198,553 and $235,878,
respectively.

Research and Development

Sponsored research revenue is recognized based on the percentage of total
research payments to be received in relation to the total research and
development costs to be incurred under the specific research agreements. All
research and development costs, both generated internally and from research and
development contracts, are expensed as incurred. The Company allocates certain
indirect costs to research and development expenses which consist primarily of
overhead related to the administration of research and development activities.

Net Loss Per Common Share

Net loss per common share has been computed by dividing the net loss, which
has been increased for periodic accretion and accrued dividends on the Series A
Convertible Preferred Stock issued in October 1994, by the weighted average
number of shares of Common Stock outstanding during the periods. In all
applicable years, all Common Stock equivalents were antidilutive and,
accordingly, were not included in the computation.

Pending Accounting Change

In March 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting No. 128, "Earnings Per Share." Statement 128 simplifies the
standards for computing earnings per share previously found in APB Opinion No.
15, Earnings per Share, and makes them comparable to international earnings per
share standards. The Statement also retroactively revises the presentation of
earnings per share in the financial statements. The Company will adopt this
Standard for the year ended December 31, 1997 and has not currently quantified
the effect of applying the new standard.

Use of Estimates

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities at the
date of the financial statements and the reported amounts of expenses during the
reporting period. Actual results could differ from those estimates.

F-7

ENERGY BIOSYSTEMS CORPORATION

NOTES TO FINANCIAL STATEMENTS-(CONTINUED)

Presentation

Certain reclassifications have been made to prior year balances to conform
to current year presentation.

3. FURNITURE, EQUIPMENT AND LEASEHOLD IMPROVEMENTS

A summary of furniture, equipment and leasehold improvements is as follows:

December 31,
---------------------------
1995 1996
------------- ------------

Office furniture and equipment $ 330,312 $ 395,332
Laboratory equipment 2,454,320 3,176,179
Computer equipment 683,218 805,850
Leasehold improvements 1,667,120 1,694,489
Equipment under capital lease 55,203 55,203
Automobiles 23,670 23,670
----------- -----------
$ 5,213,843 $ 6,150,723
Less--Accumulated depreciation (1,891,234) (3,014,088)
----------- -----------

Furniture, equipment and leasehold
improvements, net $ 3,322,609 $ 3,136,635
=========== ===========

4. STOCKHOLDERS' EQUITY

Series A Convertible Preferred Stock

On March 19, 1993, the Company filed an Amended and Restated Certificate of
Incorporation pursuant to which, among other things, the authorized shares of
Preferred Stock were increased from 2,400,000 to 5,000,000.

In October 1994, the Company offered and sold 480,000 shares of Series A
Convertible Preferred Stock at $50.00 per share. The net proceeds from the
offering were approximately $22.2 million. The placement agents for the Series A
Convertible Preferred Stock received warrants to purchase an aggregate of 28,800
shares of Series A Convertible Preferred Stock at an exercise price of $50.00
per share of Series A Convertible Preferred Stock, in addition to customary
commissions.

Dividends on the Series A Convertible Preferred Stock are cumulative and
payable semi-annually from October 27, 1994, at an annual rate equal to $4.00
per share if paid in cash and $4.50 per share if paid in Common Stock. The
shares of Series A Convertible Preferred Stock are convertible into Common Stock
at the option of the holder at a conversion price equal to $8.25 per share
subject to adjustment in certain circumstances. The Series A Convertible
Preferred Stock, if not earlier redeemed, must be redeemed on November 7, 1999
at the redemption price. The redemption price, which is equal to $50.00 per
share plus accrued and unpaid dividends, may be paid in shares of Common Stock
or cash or in a combination of Common Stock and cash, at the Company's option.
It is the Company's intent, however, to redeem the Series A Convertible
Preferred Stock for Common Stock. Accordingly, the Series A Convertible
Preferred Stock is included in stockholders' equity.

The carrying amount of the Preferred Stock is increased for accrued and
unpaid dividends plus periodic accretion, using the effective interest method,
such that the carrying amount will equal the redemption amount on November 7,
1999.

F-8

ENERGY BIOSYSTEMS CORPORATION

NOTES TO FINANCIAL STATEMENTS-(CONTINUED)

Common Stock

On March 19, 1993, the Company filed an Amended and Restated Certificate of
Incorporation pursuant to which, among other things, the authorized shares of
Common Stock were increased from 20,000,000 to 30,000,000.

In March 1995, the Company adopted a Stockholder Rights Plan (the "Rights
Plan") in which Preferred Stock Purchase Rights (the "Rights") were distributed
for each share of Common Stock held as of the close of business on March 27,
1995 and are distributed to each share of Common Stock issued thereafter until
the earlier of (i) the Distribution Date (as defined in the Rights Plan), (ii)
the date Rights are redeemed or (iii) March 8, 2005. The Rights Plan is designed
to deter coercive takeover tactics and to prevent an acquirer from gaining
control of the Company without offering a fair price to all of the Company's
stockholders. The Rights will expire on March 8, 2005.

Each Right entitles stockholders to buy one-hundredth of a share of a new
series of Junior Preferred Stock of the Company at an exercise price of $50.00
per one-hundredth of a share. The Rights are exercisable only if a person
acquires beneficial ownership of 20% or more of the Company's outstanding Common
Stock. The Rights Plan grandfathers certain stockholders who beneficially owned
more than 20% of the outstanding shares of the Company's Common Stock on the
effective date of the Rights Plan from triggering the exercisability of the
Rights.

5. STOCK OPTIONS

The 1992 Stock Compensation Plan (the "1992 Plan") is composed of non-
qualified stock options, incentive stock options, year-end stock bonuses and
restricted and non-restricted stock grants. Under the 1992 Plan, 2,031,030
shares of Common Stock are reserved for issuance upon the exercise of stock
options. Under a 1994 Non-Employee Director Option Plan, composed of non-
qualified stock options, 175,000 shares of Common Stock are reserved for
issuance upon the exercise of stock options.

At December 31, 1996, employees had been granted options to purchase
1,637,638 shares of Common Stock pursuant to the 1992 Plan. Additionally, as of
December 31, 1996 consultants and directors had been granted options to purchase
386,155 shares of Common Stock that were not issued under the 1992 Plan. Options
generally vest over a three-year period and upon the earlier of the completion
of the specified performance milestones or nine years and ten months from the
date of grant. The options expire ten years from the date of grant. At December
31, 1996, 1,113,184 shares of Common Stock were exercisable at per share
exercise prices ranging from $.296 to $13.00.

The Company accounts for its stock options under APB Opinion No. 25 under
which no compensation cost has been recognized. The Company records deferred
compensation for the difference between the exercise price and the fair market
value on the measurement date. During 1994, 1995 and 1996, the Company issued
all options at fair market value. Had compensation cost for these options been
determined consistent with FASB Statement No. 123, the Company's net loss and
loss per share would have been increased to the following pro forma amounts:

1995 1996
---- ----
Net Loss: As Reported $(7,247,716) $(9,232,780)
----------- -----------
Pro Forma $(7,439,375) $(9,627,267)
----------- -----------

Net Loss Per Share: As Reported $ (0.95) $ (1.04)
----------- -----------
Pro Forma $ (0.97) $ (1.08)
----------- -----------

Because the Statement 123 method of accounting has not been applied to
options granted prior to January 1, 1995, the resulting pro forma compensation
cost may not be representative of that expected in future years. A summary of

F-9

ENERGY BIOSYSTEMS CORPORATION

NOTES TO FINANCIAL STATEMENTS-(CONTINUED)

the status of the Company's stock options at December 31, 1994, 1995 and 1996
and changes during the years then ended is presented in the table and narrative
below:

1992 Plan Options not issued under Plan
--------------------------- ---------------------------------------------
Number Weighted Avg. Number Weighted Avg.
of Options Exercise Price of Options Exercise Price
----------- -------------- ------------------------------ --------------

December 31, 1993 1,194,963 $ 3.28 994,920 $ 0.83
Granted 210,840 8.34 60,000 10.00
Exercised (94,580) 2.67 (29,200) 1.56
Forfeited (42,159) 4.93 -- --
--------- ------ ---------
Balance at December 31, 1994 1,269,064 4.04 1,025,720 1.34
Granted 270,880 5.03 -- --
Exercised (126,949) 1.86 (145,000) 0.64
Forfeited (19,550) 10.08 -- --
--------- ------ --------- ------
Balance at December 31, 1995 1,393,445 4.35 880,720 1.46
Granted 286,170 6.46 -- --
Exercised (26,645) 1.83 (562,565) 0.57
Forfeited (15,332) 8.49 -- --
--------- ------
Balance at December 31, 1996 1,637,638 $ 4.74 318,155 $ 3.02
========= ====== ========= ======

Exercisable at December 31, 1994 685,056 $ 2.55 959,020 $ 0.86
Exercisable at December 31, 1995 652,466 $ 3.21 838,220 $ 1.08
Exercisable at December 31, 1996 727,029 $ 3.77 318,155 $ 3.02

The weighted average fair value of the options issued under the 1992 Plan for
the years ended December 31, 1995 and 1996 was $3.98 and $4.92, respectively.

During the years ended December 31, 1994, 1995 and 1996, the Company granted
20,000, 24,000 and 24,000 options, respectively, under the Non-Employee Director
Option Plan. These options are fully vested upon issuance. The weighted
average exercise price per share on these grants was $8.00, $4.00 and $7.88,
respectively. As of December 31, 1994, 1995 and 1996, the Company had 20,000,
44,000 and 68,000 options exercisable, respectively, under this plan with
weighted average exercise price of $8.00, $5.82 and $6.54 respectively. The
weighted average fair market value of the options issued under this plan during
the years ended December 31, 1995 and 1996 was $3.04 and $5.31, respectively.

The fair market value of each option grant is estimated on the date of grant
using the Black-Scholes option pricing model with the following weighted-average
assumptions used for grants in 1995 and 1996, respectively: risk-free interest
rates of 6.6 and 6.5 percent for the 1992 Plan options and 6.6 and 6.9 percent
for the Non-Employee Director Plan options; expected dividend yields of zero for
both the 1992 Plan and the Non-Employee Director Plan; expected lives of nine
years and ten months for all options; and expected volatility of 60.5 and 65.4
percent for the 1992 Plan and 58.3 and 65.1 percent for the Non-Employee
Director Plan.

6. FEDERAL INCOME TAXES

The Company has had losses since inception and, therefore, has not been
subject to federal income taxes. As of December 31, 1996, the Company had
accumulated net operating loss ("NOL") and research and development tax credit
carryforwards for income tax purposes of approximately $34,750,000 and $980,000,
respectively. These carryforwards begin to expire in 2005. The Tax Reform Act
of 1986 provided for an annual limitation on the use of NOL and tax credit
carryforwards following certain ownership changes that limit the Company's
ability to utilize these carryforwards. In April 1991 and October 1994, the
Company underwent a "more than 50 percent change in ownership" as defined by
Internal Revenue Code Section 382. Additionally, because U.S. tax laws limit
the time during which NOL and tax credit

F-10

ENERGY BIOSYSTEMS CORPORATION

NOTES TO FINANCIAL STATEMENTS-(CONTINUED)

carryforwards may be applied against future taxable income and tax liabilities,
the Company may not be able to take full advantage of its NOL and tax credits
for federal income tax purposes.

Significant components of the Company's net deferred tax asset at December
31, 1995 and 1996 are as follows:

1995 1996
------------- -------------
Deferred tax assets relating to:
- --------------------------------
Federal net operating loss
carryforwards......................... $ 8,475,689 $ 11,814,351
Research and development credit
carryovers............................ 923,338 989,171
Capital and Texas business loss
carryforwards......................... 301,346 357,846
Book/tax differences on depreciable,
amortizable and other assets and
accrued liabilities................... 73,081 263,347
Deferred revenue and unrealized gains 451,350 65,790
------------ ------------

Deferred tax valuation reserve......... (10,224,804) (13,490,505)
Net deferred tax asset................. $ -- $ --
============ ============

Beginning January 1, 1993, the Company adopted SFAS 109 which requires
recognition of deferred tax liabilities and assets for the expected future tax
consequences of events that have been recognized in the financial statements or
tax returns. Since the Company has had a net operating loss carry forward since
inception and there is no assurance of future taxable income, a valuation
allowance has been established to fully offset the deferred tax assets.

7. LICENSE AND RESEARCH AGREEMENTS

To supplement its research and development budgets, the Company intends to
seek additional collaborative research and development agreements with corporate
partners.

In this regard, the Company entered into an agreement with The
Carbide/Graphite Group, Inc. ("Carbide/Graphite") in December 1995 to
collaborate on the development of the Company's BDS technology for the removal
of sulfur from decant oil. Under the terms of the agreement, the Company will be
primarily responsible for customizing and commercializing a biocatalyst and
desulfurization system specifically for decant oil. Carbide/Graphite will be
primarily responsible for providing the development and commercialization
funding for this particular BDS process. The Company recognized $150,000 in
sponsored research revenue as of December 31, 1996.

The Company signed an agreement with The M.W. Kellogg Company ("M.W.
Kellogg") in August 1994, to collaborate on the development and
commercialization of the Company's biocatalytic desulfurization ("BDS")
technology. Under the collaboration, M.W. Kellogg will serve as an engineering
partner to the Company during completion of the BDS development process and will
be the exclusive provider of the basic engineering design services required for
the commercial units. In return for these services, M.W. Kellogg will receive a
portion of the site license fee generated by the sale of BDS units. The
collaboration has a minimum term of at least five years or the completion of 20
BDS units, whichever is longer, and has applications to all biorefining
technologies the Company develops. During the first phase of the collaboration,
M.W. Kellogg provided up to 500 engineering work hours of service at no cost to
the Company. M.W. Kellogg has also agreed to provide an additional 1,500 work
hours per year of service at M.W. Kellogg offices at reduced rates, of which 500
had been utilized by the Company at December 31, 1996.

In July 1994, the Company entered into an agreement with Total Raffinage
Distribution S.A. ("Total") to collaborate on the application of the Company's
biodesulfurization process to diesel fuel streams. Following the evaluation of
results from the Company's domestic pilot operation, it is anticipated that
Total will build and operate at Total's expense a pilot BDS unit at Total's
European Centre for Research and Technology. Upon successful economic trials of
the pilot unit, Total plans to build the first commercial BDS unit at one of its
refineries. The Company and Total

F-11

ENERGY BIOSYSTEMS CORPORATION

NOTES TO FINANCIAL STATEMENTS-(CONTINUED)

will each bear their own costs and expenses incurred under the collaboration. In
addition, as part of its obligations under the agreement, Total will provide the
Company with the use of analytical equipment valued at approximately $200,000.
The Total agreement provides that upon commercialization, the site licenses will
be waived on Total's first commercial BDS unit. In addition, Total will be
entitled to receive a ten percent (10%) discount on future site licenses and
service fees until it has recovered two and one-half times its research cost and
expenses for BDS projects under the agreement. The Company expects that the
development alliance with Total will facilitate commercialization of the BDS
technology for middle distillates and facilitate the Company's entrance into the
European market.

In December 1993, the Company entered into an alliance with Koch Refining
Company ("Koch") to facilitate the development of BDS technology in crude oil.
Under the terms of the alliance, the Company will be primarily responsible for
improving the performance of the biocatalyst used in the desulfurization
process. Koch will be primarily responsible for selecting and improving the
target oil stream as well as testing desulfurized product quality. Koch will
also provide engineering support as needed in the development of a BDS unit for
Koch's operation. The Company and Koch will each bear their own costs and
expenses incurred in connection with the collaboration. Repayment will be in
the form of a ten percent (10%) rebate on desulfurization processing fees
charged to Koch until Koch has been repaid their contribution of BDS development
costs. The Company expects that the development alliance with Koch will
facilitate commercialization of the Company's BDS technology.

The Company entered into a license agreement with Stanford University in
November 1993 for the use of their patented recombinant DNA technology, which
may be employed in the development of the Company's BDS process. The license
requires a minimum annual advance on earned royalties of $10,000.

In July 1993, the Company entered into an agreement with the Exploration
and Development Division of Texaco, Inc. ("Texaco") to facilitate the
development of the Company's BDS technology in crude oil. Under the terms of the
alliance, the Company will be primarily responsible for improving the
performance of the biocatalyst used in the desulfurization process. Texaco will
be primarily responsible for field operations and analytical chemistry work with
respect to the application of the Company's BDS technology to crude oil. The
Company and Texaco will each bear their own costs and expenses incurred in
connection with the collaboration. In the event the Company sub-licenses
Texaco's intellectual and proprietary information, licensed by agreement to the
Company by Texaco, the Company shall pay Texaco an amount equal to ten percent
(10%) of the desulfurization processing fee charged to Texaco until such time as
the Company has paid Texaco an aggregate amount equal to two and one-half times
the aggregate amount of Texaco's direct costs and expenses incurred in
connection with the collaboration. The Company expects that the development
alliance with Texaco will facilitate commercialization of the Company's BDS
technology.

In January 1991, the Company paid $25,000 and issued 730,800 shares of its
Common Stock to the Institute of Gas Technology ("IGT") for the license to IGT's
technology for desulfurizing petroleum which expires at the later of 20 years or
when all patents related to the technology expire. As consideration for future
royalties, the Company agreed to pay IGT $400,000, of which $200,000 was paid
and charged to expense as of December 31, 1992 and the remaining $200,000 was
paid and charged to expense as of December 31, 1993. These payments eliminate
the royalty to be paid upon future revenues. Payments to IGT were approximately
none, $150,000 and none in 1994, 1995 and 1996, respectively, for research
performed under the terms of the research agreements. As part of the total
payments made to IGT in 1993, the Company had paid $150,000 under the amended
agreement which provided an additional $300,000 financing for research. The
remaining payment of $150,000 was made in June 1995.

The Company has also entered into other contracts with various institutions
for research and development. The amounts paid under these agreements totaled
$237,956, $211,500 and $114,900 for the years ended December 31, 1994, 1995 and
1996, respectively. The Company is also committed to pay these institutions
approximately $95,000 through December 1997 under various agreements.

F-12

ENERGY BIOSYSTEMS CORPORATION

NOTES TO FINANCIAL STATEMENTS-(CONTINUED)

In March 1992, the Company entered into a collaborative agreement with
Petrolite Corporation ("Petrolite") to commercialize the Company's BDS
technology. Under the terms of the agreement, both parties are to perform
research and development. Petrolite is to perform research and development in
its own laboratory at its own cost and is to fund research, as agreed under the
terms of the agreement, at the Company beginning April 1, 1992, at a rate of
$225,000 per month for the first two years of the agreement for a total of
$5,400,000. Additionally, Petrolite, under the terms of the agreement,
constructed a pilot plant at its own expense, not to exceed $1,500,000, to begin
testing the effectiveness of the BDS technology. The Company is committed to
fund research and development at its own expense in the third through fifth
years of the agreement at an annual rate equal to the greater of $2,500,000 per
year or 4% of the Company's net revenues, as defined in the agreement. As of
December 31, 1996, the Company has received $5,400,000 in research payments of
which $1,134,000 has been recognized as revenue in each of the three years ended
December 31, 1994, 1995 and 1996. The revenue recognized is based on the
percentage of total research payments to be received from Petrolite in relation
to the total research and development costs to be incurred under the terms of
the agreement. The remaining $13,500 has been recorded as deferred revenue. The
amended collaborative agreement dated October 18, 1993, provides for an expanded
territory covered by the agreement from North America, Venezuela and Mexico to
the entire world and permits the use of third party engineering and construction
companies to assist with certain matters. In return, the Company's obligation to
pay Petrolite decreased from 30% to 22% of all site licenses fees and adjusted
gross profit from the operation of the desulfurization units. In the event the
collaboration is terminated, the percentage of site license fees and adjusted
gross profit paid to Petrolite will be adjusted as outlined under the terms of
the agreement.

In October 1996, the Company entered into an agreement with Petrolite
providing the Company with the option to amend the terms of its strategic
alliance with Petrolite. Under the agreement, the Company made an initial
payment of $1 million to Petrolite in December 1996, which was expensed by the
Company when made, in exchange for the option and the extension of Petrolite's
obligations to provide operational and technical support for the pilot plant
from September 1, 1996 through December 31, 1998. If the Company exercises its
option, the percentage of site license fees and adjusted gross profit payable to
Petrolite will be reduced to 9.5% from 22%, in exchange for which the Company
will (i) assume responsibility for servicing the BDS units on site at customer
locations, (ii) pay Petrolite an additional $9 million in cash and (iii) issue
to Petrolite a warrant entitling Petrolite to purchase 138,889 shares of Common
Stock at an exercise price of $7.20 per share. The Company may exercise the
Petrolite option at any time on or before the earlier to occur of (i) ten
business days following the close of any equity financing by the Company in
which the gross cash proceeds raised in such financing (together with cash
proceeds raised by the Company in any other equity financing after the date of
the option agreement, if applicable) equal or exceed $25 million and (ii)
December 30, 1998.

In December 1994, the Company was awarded a $2 million federal grant under
the Advanced Technology Programs administered by the National Institute of
Standards and Technology ("NIST"). The three-year program funded by this grant
is dedicated to the development of a biotechnology-based method of removing
sulfur from crude oil. As of December 31, 1996, the Company has recognized
$928,012 in sponsored research revenue relating to this grant. Included in this
revenue amount is $176,403 of grant receivable from NIST. The approved budget
for 1997 commits NIST to sponsor research of approximately $1,072,000.

8. COMMITMENTS

The Company maintains a Simplified Employee Pension Plan (the "Plan") for
all employees. Under the terms of the Plan, employees are eligible to
participate after completion of six months of service. The Company contributes
an amount equal to 8% of the employees' annual compensation to the Plan.
Employees are vested immediately and there is at present no employee
contribution. Total expenses under the Plan were approximately $206,000,
$246,000 and $302,000 for the years ended December 31, 1994, 1995 and 1996,
respectively.

F-13

ENERGY BIOSYSTEMS CORPORATION

NOTES TO FINANCIAL STATEMENTS-(CONTINUED)

The Company maintains two capital leases for computer and laboratory
equipment. In addition, the Company entered into an operating lease agreement in
May 1993 for its premises. In January 1994, the Company amended its lease
agreement to include additional space. The agreement expires in 1998.

Future minimum payments under the non-cancelable operating lease and
capital leases consist of the following at December 31, 1996:

Fiscal Year Operating Capital
- ----------- --------- ---------

1997 .................................. $378,228 $11,631
1998 .................................. 303,959 --
1999 .................................. 1,158 --
-------- -------
Total minimum lease payments ..... $683,345 11,631
========
Less interest ......................... (731)
-------
Present value of future minimum lease
payments ............................. $10,900
=======

The Company incurred rent expense of $278,824, $320,456 and $391,788 during
1994, 1995 and 1996, respectively.

9. RELATED-PARTY TRANSACTIONS

The Company paid consulting fees to certain stockholders and directors
totaling $44,100, $60,021 and $12,155 during the years ended December 31, 1994,
1995 and 1996, respectively.

The former Chairman of the Board and Chief Executive Officer of Petrolite
serves as a director for the Company.

10. SUBSEQUENT EVENTS

In January 1997, the Company's Board of Directors adopted the 1996 Stock
Option Plan (the "1996 Plan"). Under the 1996 Plan, the Company may issue
options for and sell up to 100,000 shares of Common Stock to employees and
consultants of the Company. The options granted under this plan may not have an
exercise price per share less than the fair market value on the date of grant
and are limited to a term not to exceed ten years.

In February and March 1997, the Company completed a convertible preferred
stock offering resulting in net cash proceeds of approximately $10.2 million in
exchange for the sale of 224,100 shares of Series B Convertible Preferred Stock.
Dividends on the Series B Convertible Preferred Stock will be cumulative from
the date of the initial closing and will be payable semi-annually commencing May
1, 1997, at an annual rate equal to (i) $4.00 per share of Series B Convertible
Preferred Stock to the extent the dividend is paid in cash and (ii) $4.50 per
share of Preferred Stock to the extent the dividend is paid in Common Stock.
Dividends on shares of Series B Convertible Preferred Stock are payable in cash
or Common Stock or a combination thereof, at the Company's option. In connection
with the offering, the Company also completed an exchange offering in which it
exchanged 478,000 shares of Series A Convertible Preferred Stock for an equal
number of shares of its Series B Convertible Preferred Stock.

F-14