Commission File Number 1-7296

NORTHERN ILLINOIS GAS COMPANY

(Doing Business as NICOR GAS COMPANY)

(Exact name of registrant as specified in its charter)

Illinois		36-2863847
(State of Incorporation)		(I.R.S. Employer
		Identification Number)
1844 Ferry Road
Naperville, Illinois 60563-9600		(630) 983-8888
(Address of principal executive offices)		(Registrant’s telephone number)

PART I

Item 1.       Business

Nicor Gas, an Illinois corporation formed in 1954, is a wholly owned subsidiary of Nicor, a holding company. Certain terms used herein are defined in the glossary on page ii.

GENERAL

Nicor Gas, a regulated natural gas distribution utility, serves nearly 2.2 million customers in a service territory that encompasses most of the northern third of Illinois, excluding the city of Chicago. The company’s service territory is diverse and its customer base has grown steadily over the years, providing the company with a well-balanced mix of residential, commercial and industrial customers. Residential customers typically account for 45 to 50 percent of natural gas deliveries, while commercial and industrial customers each typically account for 25 to 30 percent. See Operating Statistics on page 12 for operating revenues, deliveries and number of customers by customer classification. Nicor Gas had approximately 2,100 employees at year-end 2006.

Nicor Gas maintains franchise agreements with most of the communities it serves, allowing it to construct, operate and maintain distribution facilities in those communities. Franchise agreement terms range up to 50 years. Currently, about 20 percent of the agreements will expire within five years.

Customers have the option of purchasing their own gas supplies, with delivery of the gas by Nicor Gas. The larger of these transportation customers also have options that include the use of Nicor Gas’ storage system and the ability to choose varying supply backup levels. The choice of transportation service as compared to gas sales service results in less revenue for Nicor Gas but has no direct impact on net operating results. Nicor Gas continues to deliver the natural gas, maintain its distribution system and respond to emergencies.

Nicor Gas also operates the Chicago Hub, which provides natural gas storage and transmission-related services to marketers and other gas distribution companies. The Chicago area is a major market hub for natural gas, and demand exists for storage and transmission-related services by marketers, other gas distribution companies and electric power-generation facilities. Nicor Gas’ Chicago Hub addresses that demand. Effective in the fourth quarter of 2005, the rate order received by Nicor Gas provides that Chicago Hub revenues be passed directly through to customers as a credit to Nicor Gas’ PGA rider.

SOURCES OF NATURAL GAS SUPPLY

Nicor Gas purchases natural gas supplies in the open market by contracting with producers and marketers. It also purchases transportation and storage services from interstate pipelines that are regulated by the FERC. When firm pipeline services are temporarily not needed, Nicor Gas may release the services in the secondary market under FERC-mandated capacity release provisions, with proceeds reducing the cost of gas charged to customers.

Peak-use requirements are met through utilization of company-owned storage facilities, pipeline transportation capacity, purchased storage services and other supply sources, arranged by either Nicor Gas or its transportation customers. Nicor Gas has been able to obtain sufficient supplies of natural gas to meet customer requirements. The company believes natural gas supply and pipeline capacity will be sufficiently available to meet market demands in the foreseeable future.

Natural gas supply. Nicor Gas maintains a diversified portfolio of natural gas supply contracts. Supply purchases are diversified by supplier, producing region, quantity, credit limits and available transportation. Gas supply pricing is generally tied to published price indices so as to approximate

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current market prices. These supply contracts also may require the payment of fixed demand charges to ensure the availability of supplies on any given day.

The company also purchases gas supplies on the spot market to fulfill its supply requirements or to take advantage of favorable short-term pricing. Spot gas purchases accounted for about 40 percent of the company’s total gas purchases in the last three years. The majority of such spot purchases are made during the summer months and are directed toward satisfying storage injection requirements.

As part of its purchasing practices, Nicor Gas maintains a price risk hedging strategy to reduce the risk of short-term price volatility. A disciplined approach is used to systematically forward hedge a predetermined portion of forecasted monthly volumes.

As noted previously, transportation customers purchase their own gas supplies. About one-half of the gas that the company delivers is purchased by transportation customers directly from producers and marketers.

Pipeline transportation. Nicor Gas is directly connected to eight interstate pipelines, providing access to most of the major natural gas producing regions in North America. The company’s primary long-term transportation contracts are as follows (daily availability in MMBtus):

		Availability		Contract Expiration
Natural Gas Pipeline Company (NGPL)		968,000		Various dates through March 2012
Horizon Pipeline		300,000		May 2012
Tennessee Gas Pipeline Company (TGPC)		253,000		October 2009
Midwestern Gas Transmission Company		297,000		Various dates through October 2009
Northern Natural Gas Company		206,000		October 2008
ANR Pipeline		100,000		Various dates through March 2010
Texas Gas		47,000		March 2009

The company has rights of first refusal for contract extensions except for the TGPC contract. In addition to the above contracts, Nicor Gas enters into short-term winter only transportation contracts and contracts that enhance Nicor Gas’ operational flexibility. The availability numbers shown above represent maximums during the winter heating season. In some cases, the contract levels are lower during the summer period.

Storage. Nicor Gas owns and operates eight underground natural gas storage facilities. This storage system is one of the largest in the gas distribution industry. With about 150 Bcf of annual storage capacity, the system is designed to meet about 50 percent of the company’s estimated peak-day deliveries and approximately 30 percent of its normal winter deliveries. In addition to company-owned facilities, Nicor Gas has about 40 Bcf of purchased storage services under contracts with NGPL that expire in 2009, 2010 and 2012. This level of storage capability provides Nicor Gas with supply flexibility, improves the reliability of deliveries, and can mitigate the risk associated with seasonal price movements.

COMPETITION/DEMAND

Nicor Gas is the largest natural gas distributor in Illinois and, as a regulated monopoly, has the exclusive right to distribute natural gas in its service territory. Substantially all single-family homes in Nicor Gas’ service territory are heated with natural gas. In the commercial and industrial markets, the company’s natural gas services compete with other forms of energy, such as electricity, coal, propane and oil, based on such factors as price, service, reliability and environmental impact. In addition, the company has a rate that allows negotiation with potential bypass customers, and no such customer has bypassed the Nicor Gas system since the rate became effective in 1987. Nicor Gas also offers commercial and industrial customers alternatives in rates and service, increasing its ability to compete in these markets. Other significant factors that impact demand for natural gas include weather and economic conditions.

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Natural gas deliveries are temperature-sensitive and seasonal since about one-half of all deliveries are used for space heating. Typically, about three-quarters of the deliveries and revenues occur from October through March. Fluctuations in weather have the potential to significantly impact year-to-year comparisons of operating income and cash flow. It is estimated that a 100 degree-day variation from normal (5,830 degree days annually) would impact Nicor Gas’ net income by approximately $1.6 million.

Nicor Gas’ large residential customer base provides for a relatively stable level of natural gas deliveries during weak economic conditions. The company’s industrial and commercial customer base is well diversified, lessening the impact of industry-specific economic swings. However, management believes that declines since 2000 in natural gas deliveries to industrial customers may be permanent. In addition, during periods of high natural gas prices, deliveries of natural gas can be negatively affected by conservation and the use of alternative energy sources.

REGULATION

Nicor Gas is regulated by the ICC, which establishes the rules and regulations governing utility rates and services in Illinois. Those rules or regulations that may significantly affect business performance include the following:

·

Base rates, which are set by the ICC, are designed to allow the company an opportunity to recover its costs and earn a fair return for investors. In the fourth quarter of 2005, the company received approval from the ICC for a base rate increase. For additional information about the rate order, see Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations and Item 8 - Notes to the Consolidated Financial Statements - Note 14 - Rate proceeding.

·

The company’s ICC-approved tariffs provide that the cost of natural gas purchased for customers will be fully charged to customers without markup. Therefore, the company does not profit from the sale of natural gas. Rather, the company earns income from fixed monthly charges and from variable transportation charges for delivering natural gas to customer premises. Annually, the ICC initiates a review of the company’s natural gas purchasing practices for prudence, and may disallow the pass-through of costs considered imprudent.

·	As with the cost of natural gas, the company has a tariff that provides for the pass-through of prudently incurred environmental costs related to former manufactured gas plant sites. This pass-through is also subject to annual ICC review.

The ICC also has other rules that impact the company’s operations. Changes in these rules can impact operating and capital costs.

A PBR plan for natural gas costs went into effect in 2000 and was terminated by the company effective January 1, 2003. Under the PBR plan, Nicor Gas’ total gas supply costs were compared to a market-sensitive benchmark. Savings and losses relative to the benchmark were determined annually and shared equally with sales customers. The results of the PBR plan are currently under ICC review. Additional information on the plan and the ICC review are presented in Item 8 - Notes to the Consolidated Financial Statements - Note 16 - Contingencies - Performance-Based Rate Plan.

AVAILABLE INFORMATION

Nicor Gas files various reports with the SEC. These reports include the annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 15 (d) of the Securities Exchange Act of 1934. Nicor Gas makes all of these reports available without charge to the public on the investor relations section of the company’s Internet site at www.nicor. c om as soon as reasonably practicable after Nicor Gas files them with, or furnishes them to, the SEC.

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Item 1A.       Risk Factors

The following factors are the most significant factors that can impact year-to-year comparisons and may affect the future performance of the company. New risks may emerge and management cannot predict those risks or estimate the extent to which they may affect the company’s financial performance.

Regulation of Nicor Gas, including changes in the regulatory environment in general, may adversely affect the company’s results of operations, cash flows and financial condition.

 

Nicor Gas is regulated by the ICC, which has general regulatory power over practically all phases of the public utility business in Illinois, including rates and charges, issuance of securities, services and facilities, system of accounts, investments, safety standards and transactions with affiliated interests and other matters.

Nicor Gas is permitted by the ICC’s PGA regulation to adjust the charge to its sales customers on a monthly basis to recover the company’s prudently incurred actual costs to acquire the natural gas it delivers to them. The company’s gas costs are subject to subsequent prudence reviews by the ICC for which the company makes annual filings. The annual prudence reviews for calendar years 1999-2006 are open for review and any disallowance of costs in those proceedings could adversely affect Nicor Gas’ results of operations, cash flows and financial condition. See Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations for further discussion of annual prudence reviews.

Most of Nicor Gas’ other charges are changed only through a rate case proceeding with the ICC. The charges established in a rate case proceeding are based on an approved level of operating costs and investment in utility property and are designed to allow the company an opportunity to recover those costs and to earn a fair return on that investment. To the extent Nicor Gas’ actual costs to provide utility service are higher than the levels approved by the ICC, Nicor Gas’ results of operations, cash flows and financial condition could be adversely affected until such time as it files for and obtains ICC approval for new charges through a rate case proceeding.

 

Nicor Gas is also subject to rules and regulations pertaining to the integrity of its distribution system and environmental compliance. The company’s results of operations, cash flows and financial condition could be adversely affected by any additional laws or regulations that are enacted that require significant increases in the amount of expenditures for system integrity and environmental compliance.

A change in the ICC’s approved rate mechanisms for recovery of environmental remediation costs at former manufactured gas sites, or adverse decisions with respect to the prudence of costs actually incurred, could adversely affect the company’s results of operations, cash flows and financial condition.

Current environmental laws may require the cleanup of coal tar at certain former manufactured gas plant sites. To date, Nicor Gas has identified about 40 properties for which it may in part be responsible. As of December 31, 2006, the company had recorded a liability of $19.9 million associated with certain remediation efforts. Management believes that any such costs that are not recoverable from other entities or from insurance carriers are recoverable through rates for utility services under ICC-approved mechanisms for the recovery of prudently incurred costs. A change in these rate recovery mechanisms, however, or a decision by the ICC that some or all of these costs were not prudently incurred, could adversely affect the company’s results of operations, cash flows and financial condition. See Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations for further discussion.

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An adverse decision in the proceedings concerning Nicor Gas’ PBR Plan could result in a refund obligation which could adversely affect the company’s results of operations, cash flows and financial condition.  

In 2000, Nicor Gas instituted a PBR plan for natural gas costs. Under the PBR plan, Nicor Gas’ total gas supply costs were compared to a market-sensitive benchmark. Savings and losses relative to the benchmark were determined annually and shared equally with sales customers. The PBR plan was terminated effective January 1, 2003. There are allegations that Nicor Gas acted improperly in connection with the PBR plan, and the ICC and SEC are reviewing these allegations in pending proceedings. An adverse decision or decisions in these proceedings could result in a refund or other obligations which could adversely affect the company’s results of operations, cash flows and financial condition. See Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations for further discussion of the PBR proceeding and related matters.

Nicor Gas relies on direct connections to eight interstate pipelines and extensive underground storage capacity. If these pipelines or storage facilities were unable to deliver natural gas for any reason it could impair Nicor Gas’ ability to meet its customers’ full requirements.

Nicor Gas meets its customers’ peak day, seasonal and annual gas requirements through deliveries of gas transported on interstate pipelines with which it or its gas suppliers have contracts and through withdrawals of gas from storage fields it owns or leases. Nicor Gas contracts with multiple pipelines for transportation services. If a pipeline were to fail to perform transportation or storage service, including as a result of war, acts or threats of terrorism or natural disaster , on a peak day or other day with high volume gas requirements, Nicor Gas’ ability to meet all its customers’ gas requirements may be impaired unless or until alternative arrangements for delivery of supply were put in place. Likewise, if a storage field owned by Nicor Gas, or a principal Nicor Gas-owned transmission or distribution pipeline used to deliver gas to the market, were to be out of service for any reason, including as a result of war, acts or threats of terrorism or natural disaster, this could impair Nicor Gas’ ability to meet its customers’ full requirements.

Fluctuations in weather have the potential to adversely affect the company’s results of operations, cash flows and financial condition.

When weather conditions are milder than normal, Nicor Gas has historically delivered less natural gas, and consequently may earn less income. Nicor Gas’ natural gas deliveries are temperature-sensitive and seasonal since about one-half of all deliveries are used for space heating. Typically, about three-quarters of the deliveries and revenues occur from October through March. Mild weather in the future could adversely affect the company’s results of operations, cash flows and financial condition.  

Natural gas commodity price changes may affect the company’s operating costs and competitive position, which could adversely affect its results of operations, cash flows and financial condition.

Nicor Gas is sensitive to changes in natural gas prices. Natural gas prices historically have been volatile and may continue to be volatile in the future. The prices for natural gas are subject to a variety of factors that are beyond the company’s control. These factors include, but are not limited to, the level of consumer demand for, and the supply of, natural gas, processing, gathering and transportation availability, the level of imports of, and the price of foreign natural gas, the price and availability of alternative fuel sources, weather conditions, political conditions or hostilities in natural gas producing regions.

Any changes in natural gas prices could affect the prices Nicor Gas charges, operating costs and the competitive position of products and services. In accordance with the ICC’s PGA regulations, Nicor Gas adjusts its gas cost charges to sales customers on a monthly basis to account for changes in the price of natural gas. However, changes in natural gas prices can also impact certain operating expenses such as bad debt expense, company use gas and storage-related gas expenses, financing costs and customer service expenses, and these changes can only be reflected in Nicor Gas’ charges to customers if approved

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by the ICC in a rate case. Increases in natural gas prices can also have an adverse effect on natural gas distribution margin because such increases can result in lower customer demand.

Nicor Gas is subject to margin requirements in connection with the use of derivative financial instruments and these requirements could escalate if prices move adversely.

Nicor Gas’ use of derivative instruments could adversely affect the company’s results of operations.

 

Nicor Gas uses derivative instruments, including futures, options, forwards and swaps, either traded on exchanges or executed over-the-counter with natural gas merchants as well as financial institutions, to hedge natural gas price risk. Fluctuating natural gas prices can impact company use gas and storage-related gas expenses, as well as cash flows, causing earnings and financing costs of Nicor Gas to be impacted. The use of derivative instruments that are not perfectly matched to the exposure could adversely affect the company’s results of operations, cash flows and financial condition. Also, when Nicor Gas’ derivative instruments and hedging transactions fail to qualify for hedge accounting under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities , the company’s results of operations could be adversely affected.

Adverse decisions in lawsuits seeking a variety of damages allegedly caused by mercury spillage could adversely affect the company’s results of operations, cash flows and financial condition.

Nicor Gas has incurred, and expects to continue to incur, costs related to its historical use of mercury in various kinds of equipment. Nicor Gas is a defendant in several private lawsuits, all in the Circuit Court of Cook County, Illinois, seeking a variety of damages (including bodily injury, property and punitive damages) allegedly caused by mercury spillage resulting from the removal of mercury-containing regulators. Adverse decisions regarding these claims or other mercury-related claims, to the extent they require the company to make payments in excess of amounts provided for in its financial statements, could adversely affect the company’s results of operations, cash flows and financial condition.

Transporting and storing natural gas involves numerous risks that may result in accidents and other operating risks and costs that could adversely affect the company’s results of operations, cash flows and financial condition.

Nicor Gas’ activities involve a variety of inherent hazards and operating risks, such as leaks, accidents and mechanical problems, which could cause substantial financial losses. In addition, these risks could result in loss of human life, significant damage to property, environmental pollution and impairment of Nicor Gas’ operations, which in turn could lead to substantial losses. In accordance with customary industry practice, Nicor Gas maintains insurance against some, but not all, of these risks and losses. The location of pipelines and storage facilities near populated areas, including residential areas, commercial business centers and industrial sites, could increase the level of damages resulting from these risks. The occurrence of any of these events if not fully covered by insurance could adversely affect Nicor Gas’ results of operations, cash flows and financial condition.

An inability to access financial markets could affect the execution of Nicor Gas’ business plan and could adversely affect the company’s results of operations, cash flows and financial condition.

 

Nicor Gas relies on access both to short-term money markets and longer-term capital markets as a significant source of liquidity for capital and operating requirements not satisfied by the cash flows from its operations. Management believes that Nicor Gas will maintain sufficient access to these financial markets based upon current credit ratings. However, certain disruptions outside of Nicor Gas’ control or events of default under its debt agreements may increase its cost of borrowing or restrict its ability to access one or more financial markets. Such disruptions could include an economic downturn, the bankruptcy of an unrelated energy company or downgrades to Nicor Gas’ credit ratings. Restrictions on the company’s ability to access financial markets may affect its ability to execute its business plan as

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scheduled and could adversely affect the company’s results of operations, cash flows and financial condition.

Nicor Gas has credit risk that could adversely affect the company’s results of operations, cash flows and financial condition.

Nicor Gas extends credit to its counterparties. Despite what the company believes to be prudent credit policies and the maintenance of netting arrangements, the company is exposed to the risk that it may not be able to collect amounts owed to it. If the counterparty to such a transaction fails to perform and any collateral the company has secured is inadequate, it could experience financial losses.

The company is involved in legal or administrative proceedings before various courts and agencies that could adversely affect the company’s results of operations, cash flows and financial condition.

The company is involved in legal or administrative proceedings before various courts and agencies with respect to general claims, rates, taxes, environmental, gas cost prudence reviews and other matters. Adverse decisions regarding these matters, to the extent they require the company to make payments in excess of amounts provided for in its financial statements, could adversely affect the company’s results of operations, cash flows and financial condition. See Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations for further discussion.

 

The risks described above should be carefully considered in addition to the other cautionary statements and risks described elsewhere, and the other information contained in this report and in Nicor Gas’ other filings with the SEC, including its subsequent reports on Forms 10-Q and 8-K. The risks and uncertainties described above are not the only risks Nicor Gas faces although they are the most significant risks. See Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations, Item 7A - Quantitative and Qualitative Disclosures about Market Risk, and Item 8 - Notes to the Consolidated Financial Statements - Note 8 - Income and Other Taxes and Note 16 - Contingencies for further discussion of these and other risks Nicor Gas faces.

 

Item 1B.       Unresolved Staff Comments

None.

Item 2.         Properties

The company’s properties are located in the territory described under Item 1 - Business, and are suitable, adequate and utilized in its operations.

The gas distribution, transmission and storage system includes approximately 34,000 miles of steel, plastic and cast iron main; approximately 2.0 million steel, plastic/aluminum composite, plastic and copper services connecting the mains to customers’ premises; and eight underground storage fields. Other properties include buildings, land, motor vehicles, meters, regulators, compressors, construction equipment, tools, communication and computer equipment, software and office equipment.

Most of the company’s distribution and transmission property, and underground storage fields are located on property owned by others and used by the company through easements, permits or licenses. The company owns most of the buildings housing its administrative offices and the land on which they sit.

Substantially all gas distribution properties are subject to the lien of the indenture securing Nicor Gas’ First Mortgage Bonds.

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Additional information about Nicor Gas’ business is presented in Item 1A - Risk Factors, Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations and Item 8 - Notes to the Consolidated Financial Statements.

Item 3.       Legal Proceedings

See Item 8 - Notes to the Consolidated Financial Statements - Note 16 - Contingencies, which is incorporated herein by reference.

PART II

Item 5.       Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

All of the outstanding common stock of Nicor Gas is owned by Nicor. There is no public trading market for the company’s common stock. During 2006 and 2005, the company declared dividends on its common stock totaling approximately $49 million and $38 million, respectively.

 

Item 7.       Management's Discussion and Analysis of Financial Condition and Results of Operations

 

The purpose of this financial review is to explain changes in Nicor Gas’ operating results and financial condition from 2004 to 2006 and to discuss business trends that might affect Nicor Gas. Certain terms used herein are defined in the glossary on page ii. The discussion is organized into six sections - Summary, Results of Operations, Financial Condition and Liquidity, Outlook, Contingencies and Critical Accounting Estimates.

SUMMARY

Nicor Gas, a wholly owned subsidiary of Nicor, is one of the nation’s largest natural gas distribution companies, and it is Nicor’s primary business.

Results for 2006 were higher as compared to 2005 due mainly to higher operating income. Operating income increased $5.2 million in 2006 due to the positive effects of higher margin ($19.0 million pretax increase) and a first quarter pretax mercury-related recovery of $3.8 million. These positive factors were partially offset by higher operating and maintenance expenses ($13.6 million pretax increase) and higher depreciation expense ($5.6 million pretax increase). Higher margin was due to the impact of the base rate increase (approximately $36 million pretax) and higher demand unrelated to weather (approximately $5 million pretax increase), partially offset by the negative impact of warmer weather than in 2005 (approximately $17 million pretax decrease) and the passage of Chicago Hub revenues through the PGA effective with the rate order (approximately $8 million pretax decrease).

Results for 2005 were lower as compared with 2004 due mainly to lower operating income and a decrease in property sale gains. Operating income decreased $3.3 million in 2005 due primarily to higher operating and maintenance expenses ($20.0 million pretax increase) and higher depreciation expense ($5.7 million pretax increase). The adverse impact of these factors was partially offset by higher margin ($15.7 million pretax increase). Higher margin was largely driven by higher average rates (approximately $19 million pretax increase) due in part to the rate increase which became effective during the fourth quarter of 2005 (approximately $13 million pretax), and the positive impact of colder weather than in 2004 (approximately $4 million pretax increase), partially offset by lower demand unrelated to weather (approximately $6 million pretax decrease).

Rate proceeding.     In 2005, Nicor Gas received approval from the ICC for a $54.2 million base rate increase which reflected an allowed rate of return on original-cost rate base of 8.85 percent, including a 10.51 percent cost of common equity. The order also included the authorization to pass all Chicago Hub

 

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revenues directly through to customers as a credit to Nicor Gas’ PGA rider and the shifting of certain storage-related costs from the PGA rider to base rates.  In addition, rates were established using a 10-year average for weather as opposed to the previous use of a 30-year average. These rates were implemented in the fourth quarter of 2005. Because the order shifts certain items between base rates and Nicor Gas’ PGA rider, the company estimated that, under normal weather conditions and demand as reflected in the rate case, the annual net revenue increase resulting from implementing the rate order would have been about $34.7 million under the tariffs that were placed into effect.

In October 2005, Nicor Gas and six other parties filed applications for rehearing of the final order of the rate case. In March 2006, the ICC issued its decision on rehearing in which it adjusted the amount of the annual net rate increase to $49.7 million from the $54.2 million that had been approved in the earlier order. The company estimates that because the revised order similarly shifts certain items between base rates and Nicor Gas’ PGA rider, under normal weather conditions and demand as reflected in the rate case, the increase in annual net revenue decreased to $30.2 million from the estimated $34.7 million under the previous order. Rate changes resulting from the rehearing order were prospective and went into effect on April 11, 2006. Parties, including Nicor Gas, that appealed the ICC’s rate case decision to the state appellate courts have since withdrawn their appeals. As a result, the ICC rate order is no longer subject to judicial review.

As a result of the rate order which became effective in the fourth quarter of 2005, certain storage-related costs have been recorded in operating and maintenance expense. Storage-related gas costs recorded in operating and maintenance expense during 2006 and 2005 totaled $21.4 million and $6.5 million, respectively. Storage-related gas costs incurred prior to the effective date of the rate order and recorded as cost of gas in 2005 totaled $11.1 million.

These factors are discussed in more detail in the Results of Operations section which follows.

RESULTS OF OPERATIONS

The following discussion summarizes the major items impacting Nicor Gas’ operating income.

Operating revenues. Operating revenues are impacted by changes in natural gas costs, which are passed directly through to customers without markup, subject to ICC review.

For the year 2006, revenues decreased $457.3 million as compared to 2005 due to lower natural gas costs (approximately $300 million decrease) and the negative impact of warmer weather than the corresponding period in 2005 (approximately $250 million decrease), partially offset by higher demand unrelated to weather (approximately $35 million increase) and the impact of the base rate increase (approximately $36 million).

For the year 2005, revenues increased $545.7 million as compared with 2004 due primarily to higher natural gas costs (approximately $525 million increase) and the positive impact of colder weather than in 2004 (approximately $60 million increase), partially offset by lower demand unrelated to weather (approximately $70 million decrease). These results also reflect the impact of the rate order tariffs, which became effective during the fourth quarter of 2005, and increased revenues by approximately $13 million.

Margin. Nicor Gas utilizes a measure it refers to as “margin” to evaluate the operating income impact of revenues. Revenues include natural gas costs, which are passed directly through to customers without markup, subject to ICC review, and revenue taxes, for which Nicor Gas earns a small administrative fee. These items often cause significant fluctuations in revenues, and yet they have virtually no direct impact on operating income.

 

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A reconciliation of revenues and margin follows (in millions):

		2006			2005			2004
Revenues		$	2,452.3		$	2,909.6		$	2,363.9
Cost of gas			(1,743.7	)		(2,212.4	)		(1,695.0	)
Revenue tax expense			(144.4	)		(152.0	)		(139.4	)
Margin		$	564.2		$	545.2		$	529.5

For the year 2006, margin increased $19.0 million from 2005 due primarily to the impact of the base rate increase (approximately $36 million) and higher demand unrelated to weather (approximately $5 million increase), partially offset by the negative impact of warmer weather than in 2005 (approximately $17 million decrease) and the passage of Chicago Hub revenues through the PGA effective with the rate order (approximately $8 million decrease).

For the year 2005, margin increased $15.7 million from 2004 due primarily to higher average rates (approximately $19 million increase) driven by the rate increase (approximately $13 million), and the positive impact of colder weather than in 2004 (approximately $4 million increase), partially offset by lower demand unrelated to weather (approximately $6 million decrease).

Operating and maintenance expense. The $13.6 million increase in operating and maintenance expense in 2006 as compared with the prior year reflects higher storage-related gas costs ($14.9 million increase) and company use gas ($9.9 million increase), partially offset by lower bad debt expense ($4.5 million decrease), net claims arising from normal operations ($4.5 million decrease) and payroll and benefit-related costs ($3.1 million decrease).

The $20.0 million increase in operating and maintenance expense in 2005 as compared with the prior year reflects higher bad debt expense ($12.1 million increase), company use gas ($4.0 million increase) and storage-related gas costs ($6.5 million increase in the fourth quarter). These increases were partially offset by lower net legal and claims expenses ($4.7 million decrease).

The rate order, which became effective in the fourth quarter of 2005, results in certain storage-related gas costs   being   charged to operating and maintenance expense. Prior to the effective date of the rate order, storage-related gas costs were charged to cost of gas and passed through to customers as part of the PGA rider.

Mercury-related costs (recoveries), net. Mercury-related costs (recoveries), net reflect the estimated costs, credits and recoveries associated with the company’s mercury inspection and repair program. During the first quarter of 2006, a mercury-related recovery of $3.8 million was realized. This net recovery resulted from a settlement reached with an independent contractor of Nicor Gas. Net mercury-related costs (recoveries) were insignificant in 2005 and 2004. Additional information about the company’s mercury inspection and repair program is presented in Item 8 - Notes to the Consolidated Financial Statements - Note 16 - Contingencies - Mercury.

Other income (expense), net. Pretax other income was $8.9 million, $4.0 million and $4.4 million in 2006, 2005 and 2004.

Property sale gains and losses vary from year-to-year depending upon property sales activity. During 2006, Nicor Gas realized a $3.3 million pretax gain on the sale of property. Property sale gains and losses were insignificant during 2005. During 2004, Nicor Gas realized a $5.9 million pretax gain on the sale of property. The company continues to assess its ownership of certain real estate holdings.

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Interest income was $6.3 million, $4.3 million and $1.0 million in 2006, 2005 and 2004, respectively.   The increase of $2.0 million in 2006 from 2005 was due primarily to higher interest rates and investment balances along with increased income from balances on deposit in the Nicor cash management pool. The increase of $3.3 million in 2005 from 2004 was due primarily to increased interest income from higher balances on deposit in the Nicor cash management pool.

In 2004, losses of $1.8 million were recorded related to the former PBR plan. Additional information related to the PBR plan is described in Item 8 - Notes to the Consolidated Financial Statements - Note 16 - Contingencies - Performance-Based Rate Plan.

Income tax expense. The effective income tax rate was 32.2 percent, 32.8 percent and 34.8 percent for 2006, 2005 and 2004, respectively. The decrease in the effective income tax rate in 2006 is primarily due to an increase in certain tax credits and permanent items, offset, in part, by higher pretax income (which causes a higher effective income tax rate since permanent differences and tax credits are a smaller share of pretax income). The decrease in the effective income tax rate in 2005 is primarily due to lower pretax income.

Interest expense. Interest expense for 2006 increased $2.3 million over the year-earlier period. This increase is primarily due to the impact of higher average interest rates ($1.7 million increase).

Interest expense for 2005 increased $4.8 million over the year-earlier period. This increase reflects higher estimated interest on income tax matters ($4.4 million increase) and the impact of higher average interest rates ($3.7 million increase), partially offset by the impact of lower average borrowing levels ($3.3 million decrease).

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Table of Contents

 

12

 

FINANCIAL CONDITION AND LIQUIDITY

The company believes it has access to adequate resources to meet its needs for capital expenditures, debt redemptions, dividend payments and working capital. These resources include net cash flow from operating activities, access to capital markets, lines of credit and short-term investments.

Operating cash flows. The company’s business is highly seasonal and operating cash flow may fluctuate significantly during the year and from year-to-year due to factors such as weather, natural gas prices, the timing of collections from customers, natural gas purchasing, and storage and hedging practices. The company relies on short-term financing to meet seasonal increases in working capital needs. Cash requirements generally increase over the last half of the year due to increases in natural gas purchases, gas in storage and accounts receivable. During the first half of the year, positive cash flow generally results from the sale of gas in storage and the collection of accounts receivable. This cash is typically used to substantially reduce, or eliminate, short-term debt during the first half of the year.

Nicor Gas maintains a margin account related to financial derivative transactions. This margin account may cause large fluctuations in cash needs or sources in a relatively short period of time due to daily settlements resulting from changes in natural gas futures prices. The company manages these fluctuations with short-term borrowings and investments.

Net cash flow provided from operating activities was $334.5 million, $117.4 million and $284.3 million in 2006, 2005 and 2004, respectively. The increase in operating cash flow in 2006 compared to 2005 is due primarily to the impact of lower natural gas prices on working capital. The decrease in operating cash flow provided in 2005 compared to 2004 is due, in part, to the impact of higher gas prices on working capital, coupled with the partial repayment of the income tax refund received in 2003, as discussed below.

In 2003, Nicor Gas received an income tax refund of approximately $100 million attributable to a tax loss carryback associated with a change in tax accounting method (which increased its deferred income tax liability), subject to IRS review and approval as part of normal ongoing audits. Through December 31, 2004, the total current tax benefits previously recorded under this accounting method approximated $135 million (amounts recorded were offset by increases to the deferred tax liability with no net effect on reported net federal income tax expense). In 2005, the IRS revised the regulations pertaining to the aforementioned tax accounting method. The new regulations required repayment in 2005 and 2006 of amounts previously taken as current tax deductions. During 2006 and 2005, the company reclassified income tax expense from deferred to current and repaid approximately $135 million equally over those years.

Investing activities. Net cash flow used for investing activities was $155.0 million, $184.2 million and $73.2 million in 2006, 2005 and 2004, respectively. The decrease in 2006 from 2005 is primarily due to lower cash additions to property, plant and equipment. The increase in 2005 over 2004 reflects a higher level of withdrawals from the Nicor Gas cash management pool during the 2004 period.   Nicor Gas also realized net proceeds of $3.6 million and $7.6 million on the sale of property during 2006 and 2004, respectively.

Capital expenditures are an internal measure utilized by management and represent cash additions to property, plant and equipment, adjusted for items including the accrual of work performed through period end and other non-cash items, contributions in aid of construction and expenditures associated with asset retirement obligations.   Capital expenditures decreased approximately $22 million in 2006 versus 2005 due, in part, to the absence of expenditures related to the acquisition of a storage compressor in 2005 (approximately $9 million decrease) and a reduction in costs for information technology system improvements (approximately $8 million decrease). In April 2006, the company implemented a new customer care and billing system.

Capital expenditures for 2005 increased by approximately $11 million over 2004 due primarily to increased storage system expenditures attributable to the acquisition of the previously mentioned storage compressor (approximately $9 million increase).

Capital expenditures are expected to increase in 2007 by approximately $11 million versus 2006 due, in part, to higher expenditures associated with distribution system improvements and facility expansion, partially offset by lower spending on information technology.

Financing activities. Nicor Gas has credit ratings that are among the highest in the gas distribution industry. The current credit ratings for Nicor Gas are as follows:

In the second quarter of 2006, Standard and Poor’s and Fitch reaffirmed their credit ratings of Nicor Gas. In July 2006, Moody’s Investors Service (“Moody’s”) downgraded the company’s senior secured (First Mortgage Bonds) rating to A1 from Aa3 and its senior unsecured debt rating to A2 from A1. Nicor Gas’ Prime-1 commercial paper rating was not under review by Moody’s. The company does not expect this downgrade to have a significant impact on its results of operations, cash flows or financial condition.

Nicor Gas’ debt-related financial statistics at December 31 include:

Long-term debt. The company typically uses the net proceeds from long-term debt for refinancing outstanding debt, for construction programs to the extent not provided by internally generated funds, and for general corporate purposes.

At December 31, 2006, Nicor Gas had the capacity to issue approximately $390 million of First Mortgage Bonds under the terms of its indenture, of which $75 million was available for issuance under a July 2001 shelf registration filing.   Nicor Gas believes it is in compliance with its debt covenants and believes it will continue to remain so. The long-term debt agreements do not include ratings triggers or material adverse change provisions. Substantially all properties are subject to the lien of the indenture securing Nicor Gas’ First Mortgage Bonds.

In December 2006, Nicor Gas, through a private placement, issued $50 million of First Mortgage Bonds at 5.85 percent, due in 2036. Proceeds from this issuance were applied to the maturity of the $50 million 5.55 percent First Mortgage Bond series, due in December 2006.

Short-term debt. In October 2006, Nicor Gas established a $400 million, 210-day seasonal revolver, which expires in May 2007, to replace the $400 million, 210-day seasonal revolver, which expired in April 2006. In September 2005, Nicor and Nicor Gas established a $600 million, five-year revolver, expiring September 2010. These facilities were established with major domestic and foreign banks and serve as backup for the issuance of commercial paper. The company had $350 million and $490 million of commercial paper borrowings outstanding at December 31, 2006 and 2005, respectively. The company believes it is in compliance with all debt covenants and believes it will continue to remain so.

The company expects that funding from commercial paper and related backup line-of-credit agreements will continue to be available in the foreseeable future and sufficient to meet estimated cash requirements.

Common stock. The company paid dividends of approximately $47 million, $37 million and $54 million in 2006, 2005 and 2004, respectively. Nicor Gas is restricted by the amount it can dividend to Nicor. Dividends are only allowed to the extent of Nicor Gas’ retained earnings balance.

Other. Nicor Gas is restricted by regulation in the amount it can loan to affiliates. The balance of cash advances from Nicor Gas to an affiliate at any time shall not exceed the unused balance of funds actually available to that affiliate under its existing bank credit agreements or its commercial paper facilities with unaffiliated third parties. In addition, Nicor Gas may not extend cash advances to an affiliate if Nicor Gas has any outstanding short-term borrowings.

Off-balance sheet arrangements. The company does not have off-balance sheet arrangements that would have a material effect on its financial condition.

Contractual obligations. As of December 31, 2006, Nicor Gas had contractual obligations with payments due as follows (in millions):

Purchase obligations consist primarily of natural gas purchase agreements, and natural gas transportation and storage contracts. Natural gas purchase agreements include obligations to purchase natural gas at future market prices, calculated using December 31, 2006 New York Mercantile Exchange futures prices. The company also has long-term obligations for postretirement benefits which are not included in the above table. Information regarding the company’s obligations for postretirement benefits can be found in Item 8 - Notes to the Consolidated Financial Statements - Note 9 - Postretirement Benefits.

 

Operating leases are primarily for office space and equipment. Rental expense under operating leases was $1.1 million, $1.0 million and $1.0 million in 2006, 2005 and 2004, respectively. Other long-term obligations consist primarily of redeemable preferred stock.

Nicor Gas signed an agreement in the second quarter of 2006 to purchase approximately 16 Bcf of synthetic natural gas annually for a 20-year term beginning as early as 2010. Since the agreement is contingent upon various milestones to be achieved by the counterparty to the agreement and the fact that the counterparty can terminate, without penalty, prior to the realization of these milestones, the company’s obligation under this agreement is not certain at this time.

OUTLOOK

Nicor Gas’ outlook assumes normal weather for 2007, but excludes, among other things, any future impacts associated with the ICC’s PBR plan/PGA review or other contingencies. While these items could materially affect 2007 earnings, they are currently not estimable.  

 

Nicor Gas expects higher pretax operating results (after removing the $3.8 million impact of the 2006 mercury-related insurance recovery) due, in part, to increased natural gas deliveries attributable to normal weather and lower operating and maintenance expenses, partially offset by higher depreciation costs. Operating and maintenance expenses are expected to be lower due primarily to lower storage-related gas costs and natural gas and fuel costs to operate company equipment and facilities. The company estimates that a 100-degree day variation from normal weather would affect Nicor Gas’ net income by approximately $1.6 million.

CONTINGENCIES  

The following contingencies of Nicor Gas are in various stages of investigation or disposition. Although in some cases the company is unable to estimate the amount of loss reasonably possible in addition to any amounts already recognized, it is possible that the resolution of these contingencies, either individually or in aggregate, will require the company to take charges against, or will result in reductions in, future earnings. It is the opinion of management that the resolution of these contingencies, either individually or in aggregate, could be material to earnings in a particular period but is not expected to have a material adverse impact on Nicor Gas’ liquidity or financial condition.

PBR plan . Nicor Gas’ PBR plan for natural gas costs went into effect in 2000 and was terminated by the company effective January 1, 2003. Under the PBR plan, Nicor Gas’ total gas supply costs were compared to a market-sensitive benchmark. Savings and losses relative to the benchmark were determined annually and shared equally with sales customers. The PBR is currently under ICC review. There are allegations that the company acted improperly in connection with the PBR plan, and the ICC and others are reviewing these allegations. On June 27, 2002, the Citizens Utility Board (“CUB”) filed a motion to reopen the record in the ICC’s proceedings to review the PBR plan (the “ICC Proceedings”). As a result of the motion to reopen, Nicor Gas, the Cook County State’s Attorney Office (“CCSAO”), the staff of the ICC and CUB entered into a stipulation providing for additional discovery. The Illinois Attorney General’s Office (“IAGO”) has also intervened in this matter. In addition, the IAGO issued Civil Investigation Demands (“CIDs”) to CUB and the ICC staff. The CIDs ordered that CUB and the ICC staff produce all documents relating to any claims that Nicor Gas may have presented, or caused to be presented, false information related to its PBR plan. The company has committed to cooperate fully in the reviews of the PBR plan.

In response to these allegations, on July 18, 2002, the Nicor Board of Directors appointed a special committee of independent, non-management directors to conduct an inquiry into issues surrounding natural gas purchases, sales, transportation, storage and such other matters as may come to the attention of the special committee in the course of its investigation. The special committee presented the report of its counsel (“Report”) to Nicor’s Board of Directors on October 28, 2002. A copy of the report is available at the Nicor website and has been previously produced to all parties in the ICC Proceedings.

 

In response, the Nicor Board of Directors directed the company’s management to, among other things, make appropriate adjustments to account for, and fully address, the adverse consequences to ratepayers of the items noted in the Report, and conduct a detailed study of the adequacy of internal accounting and regulatory controls . The adjustments were made in prior years’ financial statements resulting in a $24.8 million liability. Included in such $24.8 million liability is a $4.1 million loss contingency. A $1.8 million adjustment to the previously recorded liability, which is discussed below, was made in 2004 increasing the recorded liability to $26.6 million. In addition, Nicor Gas estimates that there is $26.9 million due to the company from the 2002 PBR plan year, which has not been recognized in the financial statements due to uncertainties surrounding the PBR plan. The net of these items and interest income on certain components results in a $1.0 million reimbursement the company plans to seek in testimony to be filed in compliance with the new scheduling order discussed below. By the end of 2003, the company completed steps to correct the weaknesses and deficiencies identified in the detailed study of the adequacy of internal controls.

Pursuant to the agreement of all parties, including the company, the ICC re-opened the 1999 and 2000 purchased gas adjustment filings for review of certain transactions related to the PBR plan and consolidated the reviews of the 1999-2002 purchased gas adjustment filings with the PBR plan review.

On February 5, 2003, the CCSAO and CUB filed a motion for $27 million in sanctions against the company in the ICC Proceedings. In that motion, CCSAO and CUB alleged that Nicor Gas’ responses to certain CUB data requests were false. Also on February 5, 2003, CUB stated in a press release that, in addition to $27 million in sanctions, it would seek additional refunds to consumers. On March 5, 2003, the ICC staff filed a response brief in support of CUB’s motion for sanctions. On May 1, 2003, the Administrative Law Judges issued a ruling denying CUB and CCSAO’s motion for sanctions. CUB has filed an appeal of the motion for sanctions with the ICC, and the ICC has indicated that it will not rule on the appeal until the final disposition of the ICC Proceedings. It is not possible to determine how the ICC will resolve the claims of CCSAO, CUB or other parties to the ICC Proceedings.

In November 2003, the ICC staff, CUB, CCSAO and the IAGO filed their respective direct testimony in the ICC Proceedings. The ICC staff is seeking refunds to customers of approximately $108 million and CUB and CCSAO were jointly seeking refunds to customers of approximately $143 million. The IAGO direct testimony alleges adjustments in a range from $145 million to $190 million. The IAGO testimony as filed is presently unclear as to the amount which IAGO seeks to have refunded to customers. On February 27, 2004, the above referenced intervenors filed their rebuttal testimony in the ICC Proceedings. In such rebuttal testimony, CUB and CCSAO amended the alleged amount to be refunded to customers from approximately $143 million to $190 million. In December 2006, Nicor Gas withdrew its previously filed testimony. Nicor Gas anticipates refiling its direct testimony in compliance with the new scheduling order discussed below which it expects to be consistent with the findings of the special committee Report. Nicor Gas plans to seek a reimbursement of approximately $1 million as referenced above. In 2004, the evidentiary hearings on this matter were stayed in order to permit the parties to undertake additional third party discovery from Entergy-Koch Trading, LP (“EKT”), a natural gas, storage and transportation trader and consultant with whom Nicor did business under the PBR plan. In December 2006, the additional third party discovery from EKT was obtained and the Administrative Law Judges issued a scheduling order that provides for Nicor Gas to submit its direct testimony by April 13, 2007. No date has been set for evidentiary hearings on this matter.

During the course of the SEC investigation discussed below, the company became aware of additional information relating to the activities of individuals affecting the PBR plan for the period from 1999 through 2002, including information consisting of third party documents and recordings of telephone conversations from EKT. Review of additional information completed in 2004 resulted in the $1.8 million adjustment to the previously recorded liability referenced above.

Although the Report of the special committee’s counsel did not find that there was criminal activity or fraud, a review of this additional information (which was not available to the independent counsel who prepared the Report) and re-interviews of certain Nicor Gas personnel in 2004 indicated that certain former Nicor Gas personnel may have engaged in potentially fraudulent conduct regarding the PBR plan in violation of company policy, and in possible violation of SEC rules and applicable law. Further, certain former Nicor Gas personnel also may have attempted to conceal their conduct in connection with an ICC review of the PBR plan. The company continues to cooperate with the SEC, the U.S. Attorney’s office and the ICC on this matter. The company has reviewed all third party information it has obtained and will continue to review any additional third party information the company may obtain. The company terminated four employees in connection with this matter in 2004.

SEC and U.S. Attorney Inquiries. In 2002, the staff of the SEC informed the company that the SEC is conducting a formal inquiry regarding the PBR plan. A representative of the Office of the United States Attorney for the Northern District of Illinois also notified the company that that office was conducting an inquiry on the same matter that the SEC is investigating, and a grand jury was also reviewing this matter. In April 2004, Nicor was advised by the SEC Division of Enforcement that it intended to recommend to the SEC that it bring a civil injunctive action against Nicor, alleging that Nicor violated Sections 17(a) of the Securities Act of 1933 and Sections 10(b) and 13(a) of the Securities Exchange Act of 1934 and Rules 10b-5, 12b-20, 13a-1 and 13a-13 thereunder. On July 7, 2006, Nicor announced that it reached a tentative agreement with the SEC Staff in settlement of an anticipated civil action to which Nicor and the SEC will be parties. Under the terms of the tentative settlement, Nicor will be subject to disgorgement of one dollar, a monetary fine of $10 million and an injunction. Nicor will neither admit nor deny any wrongdoing. In July 2006, Nicor deposited the $10 million in escrow pending final approval of the tentative settlement by the SEC commissioners and entry of a final judgment by a federal court. The SEC Staff will submit the tentative settlement to the SEC commissioners for approval. The SEC commissioners have the authority to approve, modify or reject the tentative settlement. Nicor recorded a $10 million charge to its second quarter earnings in connection with this matter. As the tentative settlement is between Nicor and the SEC Staff, Nicor Gas has not recorded a liability associated with the outcome of the SEC matter. In December 2006, the U.S. Attorney advised that it is closing its separate inquiry and will not seek to prosecute the company or any individuals in connection with this matter.

Mercury. Future operating results may be impacted by adjustments to the company’s estimated mercury liability or by related recoveries. Additional information about mercury contingencies is presented in Item 8 - Notes to the Condensed Consolidated Financial Statements - Note 16 - Contingencies - Mercury.

Manufactured gas plant sites. The company is conducting environmental investigations and remedial activities at former manufactured gas plant sites. Additional information about these sites is presented in Item 8 - Notes to the Condensed Consolidated Financial Statements - Note 16 - Contingencies - Manufactured Gas Plant Sites.

Other contingencies.   The company is involved in legal or administrative proceedings before various courts and agencies with respect to general claims, rates, taxes, environmental, gas cost prudence reviews and other matters. See Item 8 - Notes to the Condensed Consolidated Financial Statements - Note 1 - Accounting Policies - Income taxes and Note 16 - Contingencies.

In addition, see Item 1A - Risk Factors and Item 7A - Quantitative and Qualitative Disclosures about Market Risk.

 

accounting estimates and policy decisions with the audit committee of its board of directors. Its critical estimates typically involve loss contingencies, derivative instruments, pension and other postretirement benefits, credit risk, unbilled revenues and regulatory assets and liabilities because they are estimates which could materially impact Nicor Gas’ financial statements.

Loss contingencies. Nicor Gas records contingent losses as liabilities when a loss is both probable and the amount or range of loss, including related legal defense costs, is reasonably estimable. When only a range of potential loss is estimable, the company records a liability for the minimum anticipated loss. Nicor Gas is involved in various legal and regulatory proceedings and is exposed to various loss contingencies. These loss contingencies are in some cases resolved in stages over time, estimates may change significantly from period to period, and the company’s ultimate obligations may differ materially from its recorded amounts. Of particular note is the PBR plan contingency at Nicor Gas and the SEC inquiry described in Item 8 - Notes to the Consolidated Financial Statements - Note 16 - Contingencies.

Derivative instruments. The rules for determining whether a contract meets the definition of a derivative instrument or qualifies for hedge accounting treatment are numerous and complex. The treatment of a single contract may vary from period to period depending upon accounting elections, changes in management’s assessment of the likelihood of future hedged transactions or new interpretations of accounting rules. As a result, management judgment is required in the determination of the appropriate accounting treatment. In addition, the estimated fair value of derivative instruments may change significantly from period to period depending upon market projections, and changes in hedge effectiveness may impact the accounting treatment. These determinations and changes in estimates may have a material impact on reported results.

Pension and other postretirement benefits. The company’s cost of providing postretirement benefits is dependent upon various factors and assumptions, including life expectancies, the discount rate used in determining the projected benefit obligation, the expected long-term rate of return on plan assets, the long-term rate of compensation increase and anticipated health care costs. Changes in these assumptions typically do not have a significant impact on the expenses recorded from year to year. However, actual experience in any one period, particularly the actual return on plan assets, often varies significantly from these mostly long-term assumptions. When cumulatively significant, the gains and losses generated from such variances are amortized into operating income over the remaining service lives of employees covered by the plans (approximately 11 years for the pension plan and 14 years for the health care plan). Additional information is presented in Item 8 - Notes to the Consolidated Financial Statements - Note 9 - Postretirement Benefits, including plan asset investment allocation, estimated future benefit payments, general descriptions of the plans, significant assumptions, the impact of certain changes in assumptions, and significant changes in estimates.

 

be material. Estimated unbilled revenues for Nicor Gas at December 31, 2006, 2005 and 2004 were $158.9 million, $300.4 million and $204.4 million, respectively.

Regulatory assets and liabilities. Nicor Gas is regulated by the ICC, which establishes the rules and regulations governing utility rates and services in Illinois. As a rate-regulated company, Nicor Gas applies SFAS No. 71, Accounting for the Effects of Certain Types of Regulation , which allows Nicor Gas to recognize the economic effects of rate regulation and, accordingly, has recorded regulatory assets and liabilities. Regulatory assets represent probable future revenue associated with certain costs that are expected to be recovered from customers through rate riders or rate cases, upon approval by the ICC. Regulatory liabilities represent probable future reductions in revenues collected from ratepayers through a rate rider or base rates. If all or a portion of Nicor Gas’ operations become no longer subject to the provisions of SFAS No. 71, a write-off of the net book value of its regulatory assets and liabilities would be required. Additional information on regulatory assets and liabilities is presented in Item 8 - Notes to the Consolidated Financial Statements - Note 1 - Accounting Policies.

NEW ACCOUNTING PRONOUNCEMENTS

In 2006, the FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, Interpretation No. 48, Accounting for Uncertainty in Income Taxes , and SFAS No. 157, Fair Value Measurements . In 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment. For more information, see Item 8 - Notes to the Consolidated Financial Statements - Note 2 - New Accounting Pronouncements.

CAUTION CONCERNING FORWARD-LOOKING STATEMENTS

This document includes certain forward-looking statements about the expectations of Nicor Gas. Although Nicor Gas believes these statements are based on reasonable assumptions, actual results may vary materially from stated expectations. Such forward-looking statements may be identified by the use of forward-looking words or phrases such as “anticipate,” “believe,” “expect,” “intend,” “may,” “planned,” “potential,” “should,” “will,” “would,” “project,” “estimate,” “ultimate”, or similar phrases. Actual results may differ materially from those indicated in the company’s forward-looking statements due to the direct or indirect effects of legal contingencies (including litigation) and the resolution of those issues, including the effects of an ICC review and an SEC inquiry, and undue reliance should not be placed on such statements.

Other factors that could cause materially different results include, but are not limited to, weather conditions; natural disasters; natural gas prices; fair value accounting adjustments; inventory valuation; health care costs; insurance costs or recoveries; legal costs; borrowing needs; interest rates; credit conditions; economic and market conditions; energy conservation; legislative and regulatory actions; tax rulings or audit results; asset sales; significant unplanned capital needs; future mercury-related charges or credits; changes in accounting principles, interpretations, methods, judgments or estimates; performance of major suppliers and contractors; labor relations; and acts of terrorism.