Underbalanced drilling techniques and horizontal drilling have known for some time and have been utilized in reducing drilling costs and increasing production. Underbalanced drilling (UBD) motivations and techniques have been examined in the literature [1]. UBD is often performed with the primary motivation of reducing formation damage and thereby increasing production, and aerated fluid is commonly employed in the drilling process. In hard rock applications, UBD is often performed with the primary motivation of increasing ROP (rate of penetration), and here air/mist drilling fluids are commonly employed. Directional and horizontal drilling techniques are important for accessing the reservoirs of interest and maximizing reservoir exposure. There are many important applications though where horizontal drilling can not performed underbalanced in an economical manner, because of limitations of the available technology. The US Department of Energy (DOE), Federal Energy Technology Center (FETC) has focused upon the need for extending the industry's current drilling capability to the point where directional and horizontal drilling through USA gas (and oil) reservoirs, with underbalanced drilling fluids ranging from aerated mud mixtures to dry air, is both technologically and economically feasible. With mud pulse measurement-while-drilling (MWD) inapplicable, survey and steering technology applied in these USA applications is often limited to wire-line steering tools, with their inherent limitations in operational flexibility and reliability, and rig-time costs. Current motor technology and drilling engineering competency in these applications is highly variable, and a comprehensive knowledge base on how best to drill the range of underbalanced applications is not known to exist. Operating and repair costs associated with the drilling tools and processes are often high in comparison to traditional continuous liquid drilling operations. In 1994, FETC solicited the industry for proposals towards development of an ?Integrated Underbalanced Directional Drilling System? (IUDDS), to address these needs. This contractor submitted a proposal, and was awarded a cost share contract for development of such a system, its capabilities to include wireless Electromagnetic (EM) MWD telemetry link, and steerable motors, both operable in all underbalanced drilling fluid environments including air. This paper is an interim report on progress, from contract initiation in October 1995 through February 1996. Specific areas of focus include the development goal, critical background technology being built upon, the resulting development methodology, project results to date, and continuing activities.