Cytochrome P450s constitute a superfamily of enzymes that catalyze the oxidation of a vast number of structurally and chemically diverse hydrophobic substrates. Herein, we describe the crystal structure of a complex between the bacterial P450BM-3 and the novel substrate N-palmitoylglycine at a resolution of 1.65 A, which reveals previously unrecognizable features of active site reorganization upon substrate binding. N-palmitoylglycine binds with higher affinity than any other known substrate and reacts with a higher turnover number than palmitic acid but with unaltered regiospecificity along the fatty acid moiety. Substrate binding induces conformational changes in distinct regions of the enzyme including part of the I-helix adjacent to the active site. These changes cause the displacement by about 1 A of the pivotal water molecule that ligands the heme iron, resulting in the low-spin to high-spin conversion of the iron. The water molecule is trapped close to the heme group, which allows it to partition between the iron and the new binding site. This partitioning explains the existence of a high-spin-low-spin equilibrium after substrate binding. The close proximity of the water molecule to the heme iron indicates that it may also participate in the proton-transfer cascade that leads to heterolytic bond scission of oxygen in P450BM-3.