NICOR INC 12/31/2006 FORM 10K



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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, 2006
or
[ ]
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
 
SECURITIES EXCHANGE ACT OF 1934
Commission File Number 1-7297
NICOR LOGO
NICOR INC.
(Exact name of registrant as specified in its charter)

Illinois
 
36-2855175
(State of Incorporation)
 
(I.R.S. Employer
   
Identification Number)
1844 Ferry Road
   
Naperville, Illinois 60563-9600
 
(630) 305-9500
(Address of principal executive offices)
 
(Registrant’s telephone number)

Securities registered pursuant to Section 12(b) of the Act:
Title of each class
 
Name of each exchange on which registered
Common Stock, par value $2.50 per share
 
New York Stock Exchange
   
Chicago Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes [X] No [ ]

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes [ ] No [X]

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 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 Regulation 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. [ ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer [X]
Accelerated filer [ ]
Non-accelerated filer [ ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes [ ] No [X]

The aggregate market value of common stock (based on the June 30, 2006 closing price of $41.50) held by non-affiliates of the registrant was approximately $1.8 billion. As of February 16, 2007, there were 44,911,933 shares of common stock outstanding.
 
DOCUMENTS INCORPORATED BY REFERENCE

Portions of the company’s 2007 Annual Meeting Definitive Proxy Statement, to be filed on or about March 14, 2007, are incorporated by reference into Part III.






Nicor Inc.

Table of Contents
 
       
 
Item No.
Description
Page No.
       
   
ii
       
   
Part I
 
 
1.
1
 
1A.
6
 
1B.
10
 
2.
10
 
3.
10
 
4.
10
   
11
       
   
Part II
 
 
5.
12
 
6.
14
 
7.
15
 
7A.
34
 
8.
36
 
9.
71
 
9A.
71
 
9B.
72
       
   
Part III
 
 
10.
73
 
11.
73
 
12.
73
 
13.
74
 
14.
74
       
   
Part IV
 
 
15.
75
   
77
   
78

 

Nicor Inc.

Glossary

ARO. Asset retirement obligation.

Chicago Hub. A venture of Nicor Gas, which provides natural gas storage and transmission-related services to marketers and other gas distribution companies.

Degree day. The extent to which the daily average temperature falls below 65 degrees Fahrenheit.
Normal weather for Nicor Gas’ service territory, for purposes of this report, is considered to be 5,830 degree days per year for 2006 and 2005, and 6,000 degree days per year for 2004.

EN Engineering. EN Engineering, L.L.C., a 50-percent-owned joint venture that provides engineering and consulting services.

FASB. Financial Accounting Standards Board.

FERC. Federal Energy Regulatory Commission, the agency that regulates the interstate transportation of
natural gas, oil and electricity.

FSP. FASB Staff Position.

Horizon Pipeline. Horizon Pipeline Company, L.L.C., a 50-percent-owned joint venture that operates an interstate regulated natural gas pipeline of approximately 70 miles, stretching from Joliet, Illinois to near the Wisconsin/Illinois border.
 
ICC. Illinois Commerce Commission, the agency that establishes the rules and regulations governing
utility rates and services in Illinois.

IRS. Internal Revenue Service.

Jobs Act. American Jobs Creation Act of 2004.

LIBOR. London Inter-bank Offered Rate.

LIFO. Last in, first out.

Mcf, MMcf, Bcf. Thousand cubic feet, million cubic feet, billion cubic feet.

MMBtus. Million British thermal units.

Nicor Advanced Energy. Prairie Point Energy, L.L.C. (doing business as Nicor Advanced Energy), a wholly owned business that provides natural gas and related services on an unregulated basis to residential and small commercial customers.

Nicor Enerchange. Nicor Enerchange, L.L.C., a wholly owned business that engages in wholesale marketing of natural gas supply services primarily in the Midwest, administers the Chicago Hub for Nicor Gas, and manages Nicor Solutions’ and Nicor Advanced Energy’s product risks, including the purchase of natural gas supplies.

Nicor Gas. Northern Illinois Gas Company (doing business as Nicor Gas Company) is a wholly owned public utility business and one of the nation’s largest distributors of natural gas.
 

Nicor. Nicor Inc., or the registrant.

Nicor Services. Nicor Energy Services Company, a wholly owned business that provides customer relationship management services to businesses and product warranty contracts, heating, ventilation and air conditioning repair, maintenance and installation services and equipment to retail markets, including residential and small commercial customers.
 
Nicor Solutions. Nicor Solutions, L.L.C., a wholly owned business that offers residential and small commercial customers energy-related products that provide for natural gas cost stability and management of their utility bill.

PBR. Performance-based rate, a regulatory plan which ended on January 1, 2003, that provided
economic incentives based on natural gas cost performance.

PGA. Nicor Gas’ Purchased Gas Adjustment.

SEC. The United States Securities and Exchange Commission.

SFAS. Statement of Financial Accounting Standard.

TEU. Twenty-foot equivalent unit, a measure of volume in containerized shipping equal to one 20-foot-
long container.

Triton. Triton Container Investments L.L.C., a cargo container leasing company in which Nicor Inc. has an investment.

Tropical Shipping. A wholly owned business and a carrier of containerized freight in the Bahamas and the Caribbean region.

 




PART I
 
Item 1.    Business
 
Nicor, an Illinois corporation formed in 1976, is a holding company. Gas distribution is Nicor’s primary business. Nicor’s subsidiaries include Nicor Gas, one of the nation’s largest distributors of natural gas, and Tropical Shipping, a leading transporter of containerized freight in the Bahamas and the Caribbean region. Nicor also owns several energy-related ventures, including Nicor Services, Nicor Solutions and Nicor Advanced Energy, which provide energy-related products and services to retail markets, and Nicor Enerchange, a wholesale natural gas marketing company. As a consolidated group, Nicor had approximately 3,900 employees at year-end 2006.

Summary financial information for Nicor’s major business segments is included in Item 8 - Notes to the Consolidated Financial Statements - Note 15 - Business Segment and Geographic Information. The following sections describe Nicor’s larger businesses. Certain terms used herein are defined in the glossary on pages ii and iii.

GAS DISTRIBUTION

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 Gas Distribution Statistics on page 23 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 the 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 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.

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.

The effect of weather variations on Nicor Gas’ results is mitigated, in part, due to weather risks within the consolidated Nicor group that are expected to be partially offsetting with the utility-bill management products marketed by Nicor Solutions and Nicor Advanced Energy. The amount of this offset will vary depending upon the time of year, weather patterns, the number of customers for these products and the market price for natural gas. In 2006 and 2004, the offsetting impact related to utility-bill management products was about one-half and one-third, respectively, of the gas distribution weather effect. In 2005, weather was near normal.

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 19 - 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 21 - Contingencies - Performance-Based Rate Plan.

Gas distribution, transmission and storage system, and other properties

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.

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.

SHIPPING

Tropical Shipping is one of the largest containerized cargo carriers in the Bahamas and the Caribbean, a region characterized by modest market growth and intense competition. The company is a major carrier of exports from the east coast of the United States and Canada to these regions. The company’s shipments consist primarily of southbound cargo such as building materials, food and other necessities for developers, manufacturers and residents in the Caribbean and the Bahamas, as well as tourist-related shipments intended for use in hotels and resorts, and on cruise ships. The balance of Tropical Shipping’s cargo consists primarily of northbound shipments of apparel and agricultural products, and inter-island shipments. Other related services such as inland transportation and cargo insurance are also provided by Tropical Shipping or other Nicor subsidiaries.

At December 31, 2006, Tropical Shipping’s operating fleet consisted of 10 owned vessels and 8 chartered vessels with a container capacity totaling approximately 5,800 TEUs. In addition to the vessels, the company owns and/or leases containers, container-handling equipment, chassis and other equipment. Real property, more than half of which is leased, includes office buildings, cargo handling facilities and warehouses located in the United States, Canada and some of the ports served.

Additional information about Tropical Shipping’s 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.

OTHER ENERGY VENTURES

Nicor owns several energy-related ventures, including three companies marketing energy-related products and services, and a wholesale natural gas marketing company. Nicor also has equity interests in joint ventures including a FERC-regulated natural gas pipeline.

Nicor Services, Nicor Solutions and Nicor Advanced Energy are businesses that provide energy-related products and services to retail markets, including residential and small commercial customers. Nicor Services operates primarily in northern Illinois and provides warranty and maintenance contracts, as well as repair and installation services of heating, air conditioning and indoor air-quality equipment, and customer and prospect management services. Nicor Solutions offers its residential and small commercial customers in the Nicor Gas service territory energy-related products that provide for natural gas price stability and management of their utility bill. These products mitigate and/or eliminate the risks to customers of colder than normal weather and/or changes in natural gas prices. Nicor Advanced Energy is certified by the ICC as an Alternate Gas Supplier, authorizing it to be a non-utility marketer of natural gas for residential and small commercial customers. Nicor Advanced Energy presently operates in northern Illinois, offering customers an alternative to the utility as its natural gas supplier.

Nicor Enerchange is a business that engages in wholesale marketing of natural gas supply services primarily in the Midwest, administers the Chicago Hub for Nicor Gas, and manages Nicor Solutions’ and Nicor Advanced Energy’s product risks, including the purchase of natural gas supplies.

Horizon Pipeline, a 50-percent-owned joint venture with NGPL, operates a natural gas pipeline of approximately 70 miles, stretching from Joliet, Illinois to near the Wisconsin/Illinois border. Nicor Gas has contracted for approximately 80 percent of Horizon Pipeline’s capacity under a 10-year agreement at rates that have been accepted by FERC.

EN Engineering, a 50-percent-owned joint venture between Nicor and A. Epstein & Sons International, is an engineering and consulting firm that specializes in the design, installation and maintenance of natural gas, petroleum and liquid pipeline facilities.

Additional information about Nicor’s other energy ventures 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.

CORPORATE

Nicor has various equity investments, the largest of which is Triton Container Investments L.L.C., a cargo container leasing business.

AVAILABLE INFORMATION

Nicor 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 13 (a) of the Securities Exchange Act of 1934. Nicor 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.com as soon as reasonably practicable after Nicor files them with, or furnishes them to, the SEC.

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’s businesses. 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.

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’s gas distribution segment 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. 

Conversely, results from products sold by Nicor Solutions and Nicor Advanced Energy generally benefit from milder than normal weather. Nicor Solutions and Nicor Advanced Energy offer utility-bill management products that mitigate and/or eliminate the risks to customers of variations in weather. Benefits or costs related to these products resulting from variances from normal weather are recorded primarily at the corporate level as a result of an agreement between the parent company and certain of its subsidiaries. To the extent weather is colder than normal in the future, the company’s results of operations, cash flows and financial condition could be adversely affected.

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

Nicor’s energy-related businesses are 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 Nicor’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’s energy-related businesses charge, 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 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’s other energy businesses are also subject to natural gas commodity price risk, arising primarily from fixed-price purchase and sale agreements, natural gas inventories and utility-bill management arrangements. Derivative instruments such as futures, options, forwards and swaps may be used to hedge these risks.

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

Nicor’s use of derivative instruments could adversely affect the company’s results of operations.
 
Nicor 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 cause earnings and financing costs of Nicor 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’s 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 involve 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’ gas distribution 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’s operations, which in turn could lead to substantial losses. In accordance with customary industry practice, Nicor 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’s results of operations, cash flows and financial condition.

An inability to access financial markets could affect the execution of Nicor’s business plan and could adversely affect the company’s results of operations, cash flows and financial condition.
 
Nicor 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 and its subsidiaries will maintain sufficient access to these financial markets based upon current credit ratings. However, certain disruptions outside of Nicor’s 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’s credit ratings. Restrictions on Nicor’s ability to access financial markets may affect its ability to execute its business plan as scheduled and could adversely affect the company’s results of operations, cash flows and financial condition.

Changes in the rules and regulations of certain regulatory agencies could adversely affect the results of operations, cash flows and financial condition of Tropical Shipping.

Tropical Shipping is subject to the International Ship and Port-facility Security Code and is also subject to the United States Maritime Transportation Security Act, both of which require extensive security assessments, plans and procedures. Tropical Shipping is also subject to the regulations of both the Federal Maritime Commission, and the Surface Transportation Board, other Federal Agencies as well as local laws, where applicable. Additional costs that could result from changes in the rules and regulations of these regulatory agencies would adversely affect the results of operations, cash flows and financial condition of Tropical Shipping.
 
Tropical Shipping’s business is dependent on general economic conditions and could be adversely affected by downturns in the economy.
 
Tropical Shipping’s business consists primarily of the shipment of building materials, food and other necessities for developers, manufacturers and residents in the Bahamas and the Caribbean region, as well as tourist-related shipments intended for use in hotels and resorts, and on cruise ships. As a result, Tropical Shipping’s results of operations, cash flows and financial condition can be significantly affected by general economic conditions in the United States, the Bahamas, Caribbean region and Canada.
 
The occurrence of hurricanes, storms and other natural disasters in Tropical Shipping’s area of operations could adversely affect its results of operations, cash flows and financial condition.
 
Tropical Shipping’s operations are affected by weather conditions in Florida, Canada, the Bahamas and Caribbean regions. During hurricane season in the summer and fall, Tropical Shipping may be subject to revenue loss, higher operating expenses, business interruptions, delays and ship, equipment and facilities damage which could adversely affect Tropical Shipping’s results of operations, cash flows and financial condition.
 
Nicor has credit risk that could adversely affect the company’s results of operations, cash flows and financial condition.

Nicor 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’s 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 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 10 - Income and Other Taxes and Note 21 - Contingencies for further discussion of these and other risks Nicor faces.

Item 1B.   Unresolved Staff Comments
 
None.
 
Item 2.    Properties
 
Information concerning Nicor and its major subsidiaries’ properties is included in Item 1 - Business, and is incorporated herein by reference. These properties are suitable, adequate and utilized in the company’s operations.
 
Item 3.    Legal Proceedings
 
See Item 8 - Notes to the Consolidated Financial Statements - Note 21 - Contingencies, which is incorporated herein by reference.
 
Item 4.    Submission of Matters to a Vote of Security Holders
 
None.

Executive Officers of the Registrant 

Name
 
Age
 
Current Position and Background
         
Russ M. Strobel
 
54
 
Chairman, Nicor and Nicor Gas (since 2005); Chief Executive Officer, Nicor (since 2005); Chief Executive Officer, Nicor Gas (since 2003); President, Nicor and Nicor Gas (since 2002); Executive Vice President, General Counsel and Secretary, Nicor and Nicor Gas (2002); Senior Vice President, General Counsel and Secretary, Nicor and Nicor Gas (2000-2002).
         
Richard L. Hawley
 
57
 
Executive Vice President and Chief Financial Officer, Nicor and Nicor Gas (since 2003); Vice President and Chief Financial Officer, Puget Energy, Inc., a holding company with its primary business being an electric and natural gas provider (2000-2002) and Puget Sound Energy, Inc., electric and natural gas provider (1998-2002).
         
Rocco J. D’Alessandro
 
48
 
Executive Vice President Operations, Nicor Gas (since December 2006); Senior Vice President Operations, Nicor Gas (2002-2006); Vice President Customer Service, Nicor Gas (1999-2002).
         
Claudia J. Colalillo
 
57
 
Senior Vice President Human Resources and Corporate Communications, Nicor and Nicor Gas (since 2002); Vice President Human Resources, Nicor and Nicor Gas (1998-2002).
         
Daniel R. Dodge
 
53
 
Senior Vice President Diversified Ventures and Corporate Planning, Nicor and Nicor Gas (since 2002); Vice President Business Development, Nicor and Nicor Gas (1998-2002).
         
Paul C. Gracey, Jr.
 
47
 
Senior Vice President, General Counsel and Secretary, Nicor and Nicor Gas (since March 2006); Vice President, General Counsel and Secretary, Nicor and Nicor Gas (2002-2006); Vice President and General Counsel, Midwest Generation, Chicago, independent power producer (2000-2002).
         
Gerald P. O’Connor
 
 
55
 
Vice President Finance and Treasurer, Nicor and Nicor Gas (since June 2006); Vice President Administration and Finance, Nicor and Nicor Gas (2004-2006); Temporary General Manager - Internal Audit, Nicor and Nicor Gas (2003-2004); Partner, Tatum Partners L.L.C., professional services (2003-2004); Vice President and Chief Financial Officer, Aux Sable Liquid Products L.L.P., natural gas processing (2000-2002).
         
Karen K. Pepping
 
42
 
Vice President and Controller, Nicor and Nicor Gas (since June 2006); Assistant Vice President and Controller, Nicor and Nicor Gas (2005-2006); Assistant Controller, Nicor and Nicor Gas (2003-2005); Assistant Corporate Controller, Wallace Computer Services, Inc., commercial printing (2002-2003); Director of Accounting, Tellabs, Inc., telecommunication equipment manufacturer (2000-2002).
         


PART II
 
Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 
Nicor common stock is listed on the New York and Chicago Stock Exchanges. At February 16, 2007, there were approximately 20,900 common stockholders of record and the closing stock price was $46.81.

   
Stock price
 
Dividends
 
Quarter
 
 High
 
 Low
 
 Declared
 
                     
2006
                   
First
 
$
43.12
 
$
39.25
 
$
.465
 
Second
   
42.29
   
38.72
   
.465
 
Third
   
44.40
   
41.01
   
.465
 
Fourth
   
49.92
   
42.38
   
.465
 
                     
2005
                   
First
 
$
38.33
 
$
35.50
 
$
.465
 
Second
   
41.87
   
35.76
   
.465
 
Third
   
42.59
   
39.10
   
.465
 
Fourth
   
42.97
   
37.42
   
.465
 
                     

In 2001, Nicor announced a $50 million common stock repurchase program, under which Nicor may purchase its common stock as market conditions permit through open market transactions and to the extent cash flow is available after other cash needs and investment opportunities. There have been no repurchases under this program during 2006 or 2005. As of December 31, 2006, $21.5 million remained authorized for the repurchase of common stock.

STOCK PERFORMANCE GRAPH

The following graph shows a five-year comparison of cumulative total returns for Nicor Common Stock, the S&P Utilities Index and the S&P 500 Index (both of which include Nicor Common Stock) as of December 31 of each of the years indicated, assuming $100 was invested on January 1, 2002, and all dividends were reinvested.

Comparison of Five-Year Cumulative Total Return

STOCK PERFORMANCE GRAPH
 
   
2002
 
2003
 
2004
 
2005
 
2006
 
                                 
Nicor
 
$
86
 
$
91
 
$
104
 
$
116
 
$
144
 
S&P Utilities
   
70
   
88
   
110
   
128
   
155
 
S&P 500
   
78
   
100
   
111
   
117
   
135
 



Nicor Inc.
                     
                           
 
 
                 
(in millions, except per share data)
                         
                           
       
Year ended December 31
 
       
2006
 
2005
 
2004
 
2003
 
2002
 
                                       
Operating revenues
$
2,960.0
 
$
3,357.8
 
$
2,739.7
 
$
2,662.7
 
$
1,897.4
 
                                       
Operating income
$
202.5
 
$
201.7
 
$
137.7
 
$
189.4
 
$
226.5
 
                                       
Income before cumulative effect of
                             
accounting change
       
$
128.3
 
$
136.3
 
$
75.1
 
$
109.8
$
128.0
 
                                       
Net income
       
$
128.3
 
$
136.3
 
$
75.1
 
$
105.3
 
$
128.0
 
                                       
Earnings per common share
                             
Basic
                                     
   Before cumulative effect of
                                     
      accounting change
       
$
2.88
 
$
3.08
 
$
1.71
 
$
2.49
 
$
2.90
 
   Basic earnings per share
         
2.88
   
3.08
   
1.71
   
2.39
   
2.90
 
                                       
Diluted
                                     
   Before cumulative effect of
                                     
      accounting change
       
$
2.87
 
$
3.07
 
$
1.70
 
$
2.48
 
$
2.88
 
   Diluted earnings per share
         
2.87
   
3.07
   
1.70
   
2.38
   
2.88
 
                                       
Dividends declared per common share
$
1.86
 
$
1.86
 
$
1.86
 
$
1.86
 
$
1.84
 
                                       
Property, plant and equipment
                             
Gross
       
$
4,479.7
 
$
4,351.3
 
$
4,143.6
 
$
3,999.5
 
$
3,872.8
 
Net
         
2,714.7
   
2,659.1
   
2,549.8
   
2,484.2
   
2,421.8
 
                                       
Total assets
$
4,090.1
 
$
4,391.2
 
$
3,975.2
 
$
3,797.2
 
$
3,524.4
 
                                       
Capitalization
                             
Long-term debt, net of
                                     
   unamortized discount
       
$
497.5
 
$
485.8
 
$
495.3
 
$
495.1
 
$
396.2
 
Mandatorily redeemable preferred stock
         
.6
   
.6
   
1.6
   
1.8
   
4.3
 
Common equity
         
872.6
   
811.3
   
749.1
   
754.6
   
728.4
 
         
$
1,370.7
 
$
1,297.7
 
$
1,246.0
 
$
1,251.5
 
$
1,128.9
 
                                       
                                       
See Item 1A - Risk Factors and Item 7 - Management's Discussion and Analysis of Financial Condition and Results
of Operations for factors that can impact year-to-year comparisons and may affect the future performance of Nicor's
business.
                                     
                                       
                                       
* The change in accounting method relates to a rescission of Emerging Issues Task Force Consensus No. 98-10,
Accounting for Contracts Involved in Energy Trading and Risk Management Activities, which disallowed the
recording of inventory at fair value. Effective January 1, 2003, Nicor’s wholesale natural gas marketing business,
Nicor Enerchange, began applying accrual accounting rather than fair value accounting to gas in storage and
certain energy-related contracts, such as storage and transportation agreements. Effective with the change, Nicor
               
recorded a $4.5 million cumulative effect loss from the change in accounting principle, which was net of $3.0 million
in income tax benefits.
                             
 
14

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

SUMMARY

Nicor is a holding company. Gas distribution is Nicor’s primary business. Nicor’s subsidiaries include Nicor Gas, one of the nation’s largest distributors of natural gas, and Tropical Shipping, a leading transporter of containerized freight in the Bahamas and the Caribbean region. Nicor also owns several energy-related ventures, including Nicor Services, Nicor Solutions and Nicor Advanced Energy, which provide energy-related products and services to retail markets, and Nicor Enerchange, a wholesale natural gas marketing company. Nicor also has equity interests in energy-related businesses.

Net income and diluted earnings per common share are presented below (in millions, except per share data):
 
   
2006
 
2005
 
2004
 
                     
Net income
 
$
128.3
 
$
136.3
 
$
75.1
 
                     
Diluted earnings per common share
   
2.87
   
3.07
   
1.70
 

Net income and diluted earnings per common share were lower in 2006 compared with 2005 due to a $10 million charge ($.22 per share and non-deductible for tax purposes) associated with the company’s outstanding SEC inquiry recorded in the second quarter of 2006, the absence of a 2005 pretax benefit of $29.9 million ($.41 per share) related to net insurance recoveries and earnings thereon related to the securities class action and shareholder derivative lawsuit settlements, and the absence of a $17 million tax benefit ($.38 per share) recognized in the fourth quarter of 2005 in connection with the Jobs Act, partially offset by a first quarter of 2006 pretax recovery of $3.8 million ($.05 per share) associated with Nicor Gas’ mercury inspection and repair program. Year over year comparisons (excluding the effects of the items noted above) reflect improved operating results across all business segments and the recognition of certain income tax benefits including those resulting from the reorganization of certain shipping and related operations.

Net income and diluted earnings per common share for 2005 compared with 2004 were impacted significantly by the absence of the 2004 first-quarter securities class action settlement charge of $38.5 million ($.52 per share) coupled with the 2005 pretax benefit of $29.9 million ($.41 per share) related to net insurance recoveries mentioned earlier. 2005 was also significantly impacted by a tax benefit of approximately $17 million ($.38 per share) in connection with the Jobs Act. Year over year comparisons were also impacted by higher operating results at Tropical Shipping and lower corporate overhead costs, partially offset by lower operating results in the gas distribution and other energy-related businesses. Results of the gas distribution business reflect the impact of the base rate increase which became effective in the fourth quarter of 2005.

For more information on the SEC inquiry, see the Contingencies section of this discussion.

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 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 would have been 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.

Details of various financial and operating information by segment can be found on the pages that follow.

Operating income by segment. Operating income (loss) by major business segment is presented below (in millions):
   
2006
 
2005
 
2004
 
                     
Gas distribution
 
$
123.9
 
$
116.9
 
$
130.8
 
Shipping
   
47.5
   
40.4
   
31.6
 
Other energy ventures
   
26.6
   
14.1
   
19.3
 
Corporate and eliminations
   
4.5
   
30.3
   
(44.0
)
   
$
202.5
 
$
201.7
 
$
137.7
 

The following summarizes operating income (loss) comparisons by major business segments:

·  
Gas distribution operating income increased $7.0 million in 2006 as compared with 2005 due to the positive effects of higher gas distribution margin ($19.0 million increase), a first quarter mercury-related recovery of $3.8 million and higher gains on property sales ($2.9 million increase). These positive factors were partially offset by higher operating and maintenance expenses ($13.7 million increase) and higher depreciation expense ($5.6 million increase). Higher gas distribution margin was primarily due 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).

Gas distribution operating income decreased $13.9 million in 2005 as compared with 2004 due to higher operating and maintenance expenses ($19.9 million increase), higher depreciation expense ($5.7 million increase), and lower gains on property sales ($5.5 million decrease). The adverse impact of these factors was partially offset by higher gas distribution margin ($17.5 million increase). Higher gas distribution margin was largely driven by higher average rates (approximately $19 million

increase) due in part to the rate increase which became effective during the fourth quarter of 2005 (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).
 
·  
Shipping operating income for 2006 increased $7.1 million as compared with 2005 due to higher operating revenues ($19.8 million increase) which were partially offset by higher operating costs ($12.7 million increase). Higher operating revenues were attributable to higher average rates ($40.0 million increase), partially offset by lower volumes shipped ($19.5 million decrease). Higher operating costs were due to higher transportation-related costs including fuel ($6.3 million increase), employee-related costs ($5.0 million increase), repairs and maintenance ($2.7 million increase) and leased freight equipment ($2.5 million increase), partially offset by lower legal and audit fees ($4.2 million decrease). Included in legal and audit fees for 2005 were approximately $5.1 million of costs incurred in connection with the repatriation of funds and the reorganization of Tropical Shipping to take advantage of the benefits of the Jobs Act.

Shipping operating income for 2005 increased $8.8 million compared with 2004 due primarily to an increase in revenue ($67.8 million increase) driven by higher average rates and increased volumes shipped across substantially all ports, partially offset by increased operating expenses ($59.0 million increase). Shipping segment operating expenses increased due primarily to higher transportation ($37.7 million increase) and payroll-related costs ($6.2 million increase), driven by general price increases and higher volumes shipped. Transportation-related costs include fuel, inland freight, vessel charter, voyage and transportation, and port costs. Higher legal and audit fees also contributed to the increase in expenses, reflecting approximately $5.1 million of costs incurred in connection with the repatriation of funds and the reorganization of Tropical Shipping.

·  
Operating income from Nicor’s other energy ventures for 2006 increased $12.5 million primarily due to higher operating income at Nicor Enerchange ($13.2 million increase), offset by lower operating results at Nicor’s energy-related products and services businesses ($0.6 million decrease). Improved results at Nicor Enerchange were primarily due to a significant positive variation in fair value adjustments associated with derivatives hedging purchases and sales of inventory, partially offset by unfavorable costing of physical sales activity. Lower operating results at Nicor’s energy-related products and services businesses were due to higher operating costs ($45.4 million increase) offset, in part, by higher operating revenues ($44.8 million increase).

Operating income from Nicor’s other energy ventures for 2005 decreased $5.2 million compared with 2004 due primarily to lower operating results at Nicor Enerchange ($6.3 million decrease). Lower Nicor Enerchange results reflect unfavorable fair value adjustments related to derivative instruments used to hedge future sales of natural gas inventory.

Nicor Enerchange purchases and holds natural gas in storage to earn a profit margin from its ultimate sale. Nicor Enerchange uses derivatives to mitigate commodity price risk in order to substantially lock-in the profit margin that will ultimately be realized. However, gas stored in inventory is required to be accounted for at the lower of weighted-average cost or market, whereas the derivatives used to reduce the risk associated with a change in the value of the inventory are accounted for at fair value, with changes in fair value recorded in operating results in the period of change. As a result, earnings are subject to volatility as the market price of derivatives change, even when the underlying hedged value of the inventory is unchanged. The volatility resulting from this accounting can be significant from period to period.

·  
“Corporate and eliminations” operating income for 2006, 2005 and 2004 were impacted by the following items:

 
In 2006, the company reached a tentative agreement with the staff of the SEC Enforcement Division in settlement of an anticipated civil action for a payment of $10 million. Nicor recorded a $10 million charge (non-deductible for tax purposes) in the second quarter associated with the outstanding SEC inquiry. For more information, see Item 8 - Notes to the Consolidated Financial Statements - Note 21 - Contingencies - SEC and U.S. Attorney Inquiries.

Included in corporate and eliminations’ 2006 operating income is approximately $9.5 million of benefits associated with Nicor’s other energy ventures’ utility-bill management products attributable to warmer than normal weather (excludes costs of approximately $0.7 million recorded within other energy ventures). Benefits or costs resulting from variances from normal weather are recorded primarily at the corporate level as a result of an agreement between the parent company and certain of its subsidiaries. The weather impact of these contracts generally serves to partially offset the gas distribution segment’s weather risk. The amount of the offset attributable to the utility-bill management products marketed by Nicor’s other energy ventures will vary depending upon a number of factors including the time of year, weather patterns, the number of customers for these products and the market price for natural gas.

In 2006 and 2005, the company recognized insurance recoveries related to previously incurred legal expenses associated with the securities class action and shareholder derivative lawsuits. The recoveries totaled $5.2 million and $2.8 million, respectively.

In 2005, the company recorded a $29.4 million recovery from an insurance carrier related to costs previously incurred by Nicor in connection with a securities class action and a related shareholder derivative action which were previously settled and a $0.5 million net recovery which was comprised of a shareholder derivative action settlement ($3.5 million) and a related Directors and Officers (“D&O”) insurance recovery ($4.0 million).

In 2004, the company recorded a $38.5 million settlement charge relating to a securities class action settlement. For more information, see Item 8 - Notes to the Consolidated Financial Statements - Note 21 - Contingencies - Other.

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

RESULTS OF OPERATIONS

Details of various financial and operating information by segment can be found in the tables throughout this review. The following discussion summarizes the major items impacting Nicor’s operating income.

Operating revenues. Operating revenues by major business segment are presented below (in millions):

   
2006
 
2005
 
2004
 
                     
Gas distribution
 
$
2,452.3
 
$
2,909.6
 
$
2,362.1
 
Shipping
   
398.3
   
378.5
   
310.7
 
Other energy ventures
   
215.9
   
157.0
   
155.3
 
Corporate and eliminations
   
(106.5
)
 
(87.3
)
 
(88.4
)
   
$
2,960.0
 
$
3,357.8
 
$
2,739.7
 

Gas distribution 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, gas distribution 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 increase).
 
For the year 2005, gas distribution revenues increased $547.5 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.

In 2006, shipping segment operating revenues increased over 2005 due to higher average rates ($40.0 million increase), partially offset by lower volumes shipped ($19.5 million decrease). Rates were higher due to general rate increases across all markets and higher cost-recovery surcharges for fuel and security. Volumes were lower due to the adverse impact of increased competition in several of the ports served, the strategic decision not to compete for certain low margin business, and changing global trade patterns.

In 2005, shipping segment operating revenues increased over 2004 due primarily to higher average rates ($41.8 million increase) and increased volumes shipped ($25.3 million increase). Rates were higher due to general rate increases across all markets and higher cost-recovery surcharges for fuel and security.
The volume increases were recognized across substantially all ports, reflecting improvements in the economy, significant increases in Bahamian and Caribbean investment, and rebuilding efforts following the 2004 hurricanes.

The 2006 increase in revenues for other energy ventures was due primarily to higher revenues at Nicor’s energy-related products and services business ($44.8 million increase) and higher revenues at Nicor Enerchange ($14.2 million increase). Higher revenues at Nicor’s energy-related products and services businesses were attributable primarily to higher average prices ($17.5 million increase) and an increase in customer contracts ($17.0 million increase). Higher revenues at Nicor Enerchange were due to a significant positive variation in fair value adjustments associated with derivatives hedging purchases and sales of inventory, partially offset by unfavorable costing of physical sales activity.

The 2005 increase in revenues for other energy ventures was due to improved revenues at Nicor’s energy-related products and services businesses ($8.3 million increase) due primarily to new business initiatives, higher contract volumes, and improved average contract pricing, partially offset by lower revenues at Nicor Enerchange ($6.5 million decrease) due primarily to unfavorable fair value adjustments discussed above under the Operating income by segment section.

Corporate and eliminations primarily reflects the elimination of gas distribution revenues against Nicor Solutions’ expenses for customers purchasing the utility-bill management products.

Gas distribution margin. Nicor utilizes a measure it refers to as “gas distribution margin” to evaluate the operating income impact of gas distribution revenues. Gas distribution 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 gas distribution revenues, and yet they have virtually no direct impact on gas distribution operating income.
 

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

   
2006
 
2005
 
2004
 
                     
Gas distribution revenues
 
$
2,452.3
 
$
2,909.6
 
$
2,362.1
 
Cost of gas
   
(1,743.7
)
 
(2,212.4
)
 
(1,695.0
)
Revenue tax expense
   
(144.4
)
 
(152.0
)
 
(139.4
)
Gas distribution margin
 
$
564.2
 
$
545.2
 
$
527.7
 

For the year 2006, gas distribution 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, gas distribution margin increased $17.5 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).

Gas distribution operating and maintenance expense. The $13.7 million increase in gas distribution 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 $19.9 million increase in gas distribution 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.

Other gas distribution operating expenses. 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 21 - Contingencies - Mercury.

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.

Shipping operating expenses. Shipping segment operating expenses increased $12.7 million in 2006 as compared with 2005 due to higher transportation-related costs including fuel ($6.3 million increase), employee-related costs ($5.0 million increase), repairs and maintenance ($2.7 million increase) and leased

freight equipment ($2.5 million increase), partially offset by lower legal and audit fees ($4.2 million decrease). Included in legal and audit fees for 2005 were approximately $5.1 million of costs incurred in connection with the repatriation of funds and the reorganization of Tropical Shipping to take advantage of the benefits of the Jobs Act.

Shipping segment operating expenses increased $59.0 million in 2005 as compared with 2004 due primarily to higher transportation-related costs, which include fuel, inland freight, vessel charter, voyage and transportation, and port costs ($37.7 million increase), and higher payroll-related costs ($6.2 million increase). The increases were due to general price increases and increased volumes shipped. Higher legal and audit fees ($5.2 million increase) also contributed to the increase. Included in these amounts were approximately $5.1 million of costs incurred in connection with repatriation of funds and the reorganization of Tropical Shipping.

Operating expenses of other energy ventures. The $46.4 million increase in the 2006 operating expenses compared with 2005 were due to higher expenses at Nicor’s energy-related products and services businesses ($45.4 million increase) reflecting a higher average cost of gas ($14.8 million increase), costs related to an increase in customer contracts ($12.4 million increase) and higher selling, general and administrative costs attributable to acquiring new customer contracts ($8.8 million increase).

The $6.9 million increase in the 2005 operating expenses compared with 2004 was due primarily to higher expenses at Nicor’s energy-related products and services businesses ($7.1 million increase), due largely to higher risk management costs and expenses related to new business initiatives, partially offset by the impact of a decreased average number of fixed utility bill management customers.

Litigation charges (recoveries), net. In the second quarter of 2006, Nicor recorded a $10 million charge (non-deductible for tax purposes) associated with the outstanding SEC inquiry. In July 2006, the company reached a tentative agreement with the staff of the SEC Enforcement Division in settlement of an anticipated civil action for a payment of $10 million. For more information, see Item 8 - Notes to the Consolidated Financial Statements - Note 21 - Contingencies - SEC and U.S. Attorney Inquiries.

In the first quarter of 2005, the company recorded a $0.5 million net recovery which was comprised of a shareholder derivative action settlement ($3.5 million) and a related D&O insurance recovery ($4.0 million). During the second quarter of 2005, the company recorded $29.4 million of income related to the recovery from an insurance carrier of costs previously incurred by Nicor in connection with a securities class action and a related shareholder derivative action which were previously settled. For more information, see Item 8 - Notes to the Consolidated Financial Statements - Note 21 - Contingencies - Other.

In the first quarter of 2004, the company recorded a $38.5 million litigation charge related to an agreement to settle the securities class actions.

Other corporate expenses and eliminations. Other corporate operating expenses (income) were ($5.2) million, ($0.8) million and $5.5 million in 2006, 2005 and 2004, respectively. In 2006 and 2005, the company recorded a benefit from insurance recoveries related to legal expenses incurred in 2004 and prior. Also included in these amounts are business development costs.

Intercompany eliminations were ($115.8) million, ($86.9) million and ($88.4) million in 2006, 2005 and 2004, respectively, and related primarily to utility-bill management products.

Interest expense. Interest expense for 2006 increased $2.3 million over the 2005 period. This increase primarily reflects the impact of higher average interest rates ($2.5 million increase).

Interest expense for 2005 increased $5.6 million over the 2004 period. This increase reflects the impact of higher average interest rates ($6.2 million increase) and higher estimated interest on income tax matters


($3.7 million increase), partially offset by the impact of lower average borrowing levels ($4.8 million decrease).

Net equity investment income. Net equity investment income increased $1.8 million in 2006 over the 2005 period due primarily to a $2.4 million gain on a sale of an equity investment recognized in the third quarter of 2006 and higher income from EN Engineering ($0.8 million increase). These items were partially offset by lower income from Triton ($1.6 million decrease).

Equity investment results for 2005 increased by $3.0 million as compared with 2004 due primarily to higher results related to low income housing investments ($1.1 million increase) and higher income from Triton ($0.9 million increase).

Equity investment results include $5.8 million, $7.4 million and $6.5 million for 2006, 2005 and 2004, respectively, for Nicor’s share of income from Triton.

Interest income. Interest income increased $3.0 million in 2006 over 2005 and $3.7 million in 2005 over 2004 due to higher average rates and higher investment balances.

Income tax expense. During December 2005, Nicor repatriated $132 million of cumulative undistributed earnings of foreign subsidiaries. The repatriation was funded by cash available from foreign subsidiaries coupled with the proceeds received by Tropical Shipping in connection with the December 2005 issuance of a $40 million two-year senior unsecured term loan. The federal income tax benefit resulting from the repatriation is approximately $17 million and was recognized in the fourth quarter of 2005. In conjunction with the repatriation, Nicor reclassified approximately $7.6 million of deferred income tax liabilities to other income tax reserves.

Effective January 2006, the company reorganized certain shipping and related operations. The reorganization allows the company to take advantage of certain provisions of the Jobs Act that provide the opportunity for tax savings subsequent to the date of the reorganization. Generally, to the extent foreign shipping earnings are not repatriated to the United States, such earnings are not expected to be subject to current taxation. In addition, to the extent such earnings are expected to be indefinitely reinvested offshore, no deferred income tax expense would be recorded by the company. For the year ended December 31, 2006, income tax expense has not been provided on approximately $29 million of foreign company shipping earnings that are expected to be indefinitely reinvested offshore. In connection with these activities, a net income tax benefit of $5.2 million from the elimination of certain deferred income taxes and $4.7 million in current income tax expense was recorded in 2006.

The overall effective income tax rate for 2006 increased to 26.3 percent from the prior year rate of 20.3 percent, due primarily to the 2005 tax benefits recorded in connection with the Jobs Act (approximately $17 million). The decline in the company’s effective income tax rate to 20.3 percent in 2005 from 28.7 percent in 2004 was also primarily a result of the tax benefits recorded in 2005 related to the Jobs Act. In addition, the 2006 effective income tax rate reflects the ongoing benefit of untaxed foreign shipping earnings, the recognition of tax benefits related to the first quarter 2006 reorganization of the company’s shipping and related operations and second quarter 2006 favorable adjustments associated with tax audits (which occur in the ordinary course of business) offset, in part, by the non-deductible $10 million charge in the second quarter 2006 associated with the company’s outstanding SEC inquiry. The 2005 effective income tax rate was adversely impacted by recording net litigation recoveries and earnings thereon ($29.9 million) at the company’s marginal tax rate of approximately 40 percent.
 
 
             
               
Gas Distribution Statistics
             
               
   
2006
 
2005
 
2004
 
                     
Operating revenues (millions)
                   
Sales
                   
Residential
 
$
1,671.1
 
$
2,031.4
 
$
1,625.5
 
Commercial
   
373.9
   
453.5
   
349.9
 
Industrial
   
42.8
   
61.8
   
49.3
 
     
2,087.8
   
2,546.7
   
2,024.7
 
Transportation
                   
Residential
   
32.0
   
27.9
   
23.6
 
Commercial
   
82.1
   
73.1
   
69.9
 
Industrial
   
41.0
   
39.2
   
39.9
 
Other
   
3.7
   
11.7
   
14.0
 
     
158.8
   
151.9
   
147.4
 
Other revenues
                   
Revenue taxes
   
147.7
   
156.4
   
143.5
 
Environmental cost recovery
   
11.6
   
21.0
   
20.6
 
Chicago Hub
   
26.4
   
11.5
   
7.9
 
Performance-based rate plan
   
-
   
-
   
(1.8
)
Other
   
20.0
   
22.1
   
19.8
 
     
205.7
   
211.0
   
190.0
 
   
$
2,452.3
 
$
2,909.6
 
$
2,362.1
 
                     
Deliveries (Bcf)
                   
Sales
                   
Residential
   
185.9
   
200.2
   
204.8
 
Commercial
   
41.8
   
44.7
   
44.3
 
Industrial
   
5.0
   
6.3
   
6.4
 
     
232.7
   
251.2
   
255.5
 
Transportation
                   
Residential
   
17.0
   
18.9
   
16.6
 
Commercial
   
80.4
   
87.5
   
84.1
 
Industrial
   
108.6
   
113.0
   
117.0
 
     
206.0
   
219.4
   
217.7
 
     
438.7
   
470.6
   
473.2
 
                     
Year-end customers (thousands) (1)
                   
Sales
                   
Residential
   
1,807
   
1,796
   
1,777
 
Commercial
   
123
   
120
   
117
 
Industrial
   
7
   
8
   
7
 
     
1,937
   
1,924
   
1,901
 
Transportation
                   
Residential
   
166
   
157
   
148
 
Commercial
   
57
   
58
   
60
 
Industrial
   
6
   
6
   
6
 
     
229
   
221
   
214
 
     
2,166
   
2,145
   
2,115
 
                     
Other statistics
                   
Degree days
   
5,174
   
5,783
   
5,637
 
Warmer than normal (2)
   
(11
%)
 
(1
%)
 
(6
%)
Average gas cost per Mcf sold
 
$
7.44
 
$
8.74
 
$
6.56
 
                     
(1) The company has redefined the customer count methodology in 2006 in conjunction with its new
   
customer care and billing system.
                   
                     
(2) Normal weather for Nicor Gas' service territory, for purposes of this report, is considered to be 5,830
 
degree days per year for 2006 and 2005 and 6,000 degree days for 2004. On a 6,000 degree day basis,
   
2006 and 2005 would have been 14% and 4% warmer than normal, respectively.
                   
 
23



Shipping Statistics
             
   
2006
 
2005
 
2004
 
                     
TEUs shipped (thousands)
   
203.1
   
214.2
   
198.0
 
Average revenue per TEU
 
$
1,961
 
$
1,764
 
$
1,569
 
                     
At end of period
                   
Ports served
   
27
   
25
   
24
 
Vessels operated at year-end
   
18
   
18
   
20
 

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 gas distribution 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 maintains margin accounts related to financial derivative transactions. These margin accounts 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 $447.0 million, $206.2 million and $317.7 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. This was partially offset by the absence of the $29.9 million of D&O net insurance recoveries, including earnings thereon, received during 2005 related to settlement costs incurred by Nicor in connection with a securities class action and a related shareholder derivative action. 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. These effects were partially offset by the $29.9 million of D&O net insurance recoveries mentioned above, and the absence of the $38.5 million pretax litigation charge in 2004 related to an agreement to settle the securities class action litigation.

In 2003, Nicor 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 $192.2 million, $154.7 million and $204.7 million in 2006, 2005 and 2004, respectively.

Capital expenditures. Capital expenditures is 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 by business segment are presented below (in millions):
 
   
Estimated
             
   
2007
 
2006
 
2005
 
2004
 
                           
Gas distribution
 
$
175
 
$
164
 
$
186
 
$
175
 
Shipping
   
21
   
17
   
11
   
9
 
Other energy ventures
   
4
   
6
   
3
   
3
 
   
$
200
 
$
187
 
$
200
 
$
187
 

Gas distribution segment capital expenditures decreased 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 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 in the gas distribution segment are expected to increase in 2007 versus 2006 due, in part, to higher expenditures associated with distribution system improvements and facility expansion, partially offset by lower spending on information technology.

Shipping segment capital expenditures for 2006 increased $6 million over 2005 due primarily to the purchase of a new vessel which was placed in service in early 2007. Shipping segment capital expenditures for 2005 increased $2 million over 2004 due primarily to higher purchases of freight handling equipment.  

Capital expenditures in the shipping segment are expected to increase in 2007 versus 2006 due primarily to higher expenditures related to freight handling equipment and facilities expansion.

Additional investing activities. Investment activities in 2006 also reflect the absence of proceeds from the 2005 sale of various investments, the third quarter 2006 funding of an escrow account associated with the tentative agreement with the staff of the SEC Enforcement Division in settlement of an anticipated civil action of $10.0 million and net proceeds of $7.0 million associated with the company’s sale of an equity investment. In 2005, additional investment activities include proceeds from the 2005 sale of various investments coupled with the absence of $21.8 million of purchases of available-for-sale securities in 2004. In 2004, the company also realized net proceeds of $8.0 million on the sale of property.

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

   
 Standard & Poor’s
 
 Moody’s
 
 Fitch
 
Nicor Inc.
                   
Commercial Paper
   
  A-1+
   
P-2
   
F-1
 
Senior Unsecured Debt
   
 AA-
   
n/a
   
A
 
Corporate Credit Rating
   
AA
   
n/a
   
n/a
 
 
Nicor Gas
                   
Commercial Paper
   
   A-1+
   
P-1
   
F-1+
 
Senior Secured Debt
   
AA
   
A1
   
AA-
 
Senior Unsecured Debt
   
 AA-
   
A2
   
A+
 
Corporate Credit Rating
   
AA
   
n/a
   
n/a
 

In the second quarter of 2006, Standard and Poor’s and Fitch reaffirmed their credit ratings of Nicor and Nicor Gas. In July 2006, Moody’s Investors Service (“Moody’s”) downgraded Nicor’s commercial paper rating to Prime-2 from Prime-1, Nicor’s preferred stock rating to Baa2 from Baa1, Nicor Gas’ senior secured (First Mortgage Bonds) rating to A1 from Aa3 and Nicor Gas’ 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’s debt-related financial statistics at December 31 include:

   
2006
 
2005
 
2004
 
Long-term obligations, net of current maturities,
as a percent of capitalization
   
36.3
%
 
37.5
%
 
39.9
%
Times interest earned, before income taxes
   
4.5
   
4.5
   
3.5
 

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 believes it is in compliance with its debt covenants and believes it will continue to remain so. Nicor’s long-term debt agreements do not include ratings triggers or material adverse change provisions. Substantially all gas distribution 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.

In December 2005, Tropical Shipping obtained a $40 million two-year senior unsecured term loan which was used along with cash available from foreign subsidiaries to fund the repatriation of $132 million of its cumulative undistributed foreign earnings under the provisions of the Jobs Act. The term loan had a floating interest rate based on LIBOR plus 0.50 percent per annum. For the purpose of obtaining a lower borrowing rate, the term loan was guaranteed by Nicor. The loan was fully paid off as of December 31, 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 $586 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. Nicor maintained its quarterly common stock dividend rate during 2006 of $0.465 per common share. The company paid dividends on its common stock of $82.9 million, $82.1 million and $82.0 million in 2006, 2005 and 2004, respectively. Nicor currently has no contractual or regulatory restrictions on the payment of dividends.

In 2001, Nicor announced a $50 million common stock repurchase program. Purchases may be made as market conditions permit through open market transactions and to the extent cash flow is available after other cash needs and investment opportunities. There were no purchases under this program in 2006, 2005 and 2004, and at December 31, 2006, $21.5 million remained authorized for the repurchase of common stock.

Preferred Stock. In November 2005, Nicor redeemed 20,062 shares of 5% Mandatorily Redeemable Preferred Stock, $50 par value, at a per share redemption price of $51 plus accrued and unpaid dividends.

Off-balance sheet arrangements. Nicor has certain guarantees, as further described in Item 8 - Notes to the Consolidated Financial Statements - Note 20 - Guarantees and Indemnities. The company believes that it is not probable that these guarantees will have a material effect on its financial condition.

Contractual obligations. As of December 31, 2006, Nicor had contractual obligations with payments due as follows (in millions):
 
                                                                                                                                                   Payments due by period                                                                               
   
Less
than 1
year
 
 
1-3
years
 
 
3-5
years
 
More
than 5
years
 
 
 
Total
 
                                 
Purchase obligations
 
$
844.9
 
$
424.2
 
$
49.1
 
$
7.6
 
$
1,325.8
 
Long-term debt
   
-
   
125.0
   
75.0
   
300.0
   
500.0
 
Fixed interest on
long-term debt
   
30.7
   
52.8
   
42.6
   
302.7
   
428.8
 
Operating leases
   
30.4
   
38.3
   
10.1
   
15.6
   
94.4
 
Other long-term obligations
   
1.8
   
1.4
   
.2
   
.6
   
4.0
 
   
$
907.8
 
$
641.7
 
$
177.0
 
$
626.5
 
$
2,353.0
 

Purchase obligations consist primarily of natural gas purchase agreements, and natural gas transportation and storage contracts in the gas distribution and wholesale natural gas marketing business segments. 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 11 - Postretirement Benefits.

Operating leases are primarily for vessels, containers and equipment in the shipping segment, office space and equipment in the gas distribution segment and office space at other energy ventures. Tropical

Shipping has certain equipment operating leases which include purchase and/or renewal options, at fair market amounts at the time of purchase or renewal. Rental expense under operating leases was $41.7 million, $37.2 million and $27.5 million in 2006, 2005 and 2004, respectively. The increase in rent expense from 2006 to 2005 was primarily driven by the addition of equipment leases and higher charter rates in the shipping segment.

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.

Other. Restrictions imposed by regulatory agencies and loan agreements limiting the amount of subsidiary net assets that can be transferred to Nicor are not expected to have a material impact on the company’s ability to meet its cash obligations.

OUTLOOK

Nicor’s 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. The company’s outlook also does not reflect the additional variability in earnings due to fair value accounting adjustments at Nicor Enerchange and other impacts that could occur because of future volatility in the natural gas markets. While these items could materially affect 2007 earnings, they are currently not estimable.

Gas Distribution. 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. The consolidated impact, however, is generally reduced somewhat because of the natural weather hedge attributable to the utility-bill management products offered by certain of Nicor’s other energy ventures.

Shipping. Tropical Shipping’s operating results are expected to be comparable to 2006. The company also continues to expect relatively low tax costs on operating earnings attributable to the January 2006 reorganization of certain shipping and related operations.

Other Energy Ventures. The company expects improved operating results in its other energy ventures resulting from improved expected results from its energy-related products and services businesses.

Other. Nicor also expects earnings to be adversely impacted by higher net interest costs and the absence of certain benefits recorded in 2006, including the gain on the sale of an equity interest, insurance recoveries of previously incurred legal costs, and certain tax-related benefits, discussed in preceding paragraphs. Because the company is assuming normal weather, 2007 also reflects the absence of the benefit recorded in 2006 from the other energy ventures’ utility-bill management products which reduced the negative effects of warmer weather in Nicor’s gas distribution segment. Additionally, 2007 excludes the $10 million charge associated with the SEC inquiry recorded in 2006.

CONTINGENCIES

The following contingencies of Nicor 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’s 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 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.

Nicor is unable to predict the outcome of the ICC’s review or the company’s potential exposure thereunder. Because the PBR plan and historical gas costs are still under ICC review, the final outcome could be materially different than the amounts reflected in the company’s financial statements as of December 31, 2006.

SEC and U.S. Attorney Inquiries. In 2002, the staff of the SEC Division of Enforcement (“SEC Staff”) informed Nicor 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 (the “U.S. Attorney”) also notified Nicor that that office was conducting an inquiry on the same matters that the SEC is investigating, and a grand jury was also reviewing these matters. In April 2004, Nicor was advised by the SEC Staff 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, the company announced that it reached a tentative agreement with the SEC Staff in settlement of an

anticipated civil action to which the company and the SEC will be parties. Under the terms of the tentative settlement, the company will be subject to disgorgement of one dollar, a monetary fine of $10 million and an injunction. The company will neither admit nor deny any wrongdoing. In July 2006, the company 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. The $10 million fine is not deductible for federal or state income tax purposes. In December 2006, the U.S. Attorney advised that it is closing its 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 Consolidated Financial Statements - Note 21 - 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 Consolidated Financial Statements - Note 21 - Contingencies - Manufactured Gas Plant Sites.

Fixed Bill Service. Nicor Services was a defendant in a purported class action. On October 7, 2005, the Circuit Court denied plaintiffs’ motion to certify the proposed class. Information about this lawsuit is presented within Item 8 - Notes to the Consolidated Financial Statements - Note 21 - Contingencies - Fixed Bill Service.

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 Consolidated Financial Statements - Note 10 - Income and Other Taxes and Note 21 - Contingencies.

In 2004, one of Nicor’s Directors and Officers insurance carriers agreed to pay $29.0 million to a third party escrow agent on behalf of Nicor and its insured directors and officers to be used to satisfy Nicor directors’ and officers’ liabilities and expenses associated with claims asserted against them in then pending securities class actions and shareholder derivative lawsuits and related matters, with any remaining balance to be paid to Nicor. The securities class actions were settled in 2004 for a payment by Nicor of $38.5 million. As a result of this settlement and the settlement of the shareholder derivative lawsuits in 2005, the escrow was terminated and the $29.0 million, plus earnings of approximately $0.4 million, held by the escrow agent was paid to Nicor in the second quarter of 2005. These recoveries were recorded in “Litigation charges (recoveries), net” in the Consolidated Statement of Operations for the year ended December 31, 2005. In addition, Nicor had asserted claims against its excess insurance carrier arising out of these securities class actions and shareholder derivative lawsuits. In connection with the settlement of the shareholder derivative lawsuits, in the first quarter of 2005, Nicor’s excess insurance carrier paid Nicor $4 million. Under the terms of the shareholder derivative lawsuits settlement, Nicor agreed to adopt certain new corporate governance policies and to pay $3.5 million out of the $4 million received from the excess insurance carrier to plaintiffs’ attorneys to reimburse them for the fees and expenses expended in pursuing the derivative actions. The $0.5 million net of these payments was reflected in “Litigation charges (recoveries), net” in the Consolidated Statement of Operations for the year ended December 31, 2005. Additionally, Nicor received payments of $5.2 million and $2.8 million in 2006 and 2005, respectively, from insurance carriers as reimbursement of legal defense costs in connection with these matters. These payments have been recorded in “Other corporate eliminations and expenses” in the Consolidated Statement of Operations for the respective years.

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

CRITICAL ACCOUNTING ESTIMATES

Nicor prepares its consolidated financial statements in accordance with accounting principles generally accepted in the United States, which regularly require Nicor’s management to exercise judgment in the selection and application of accounting methods. The application of accounting methods includes making estimates using subjective assumptions and judgments about matters that are inherently uncertain.

The use of estimates and the selection of accounting policies affect Nicor’s reported results and financial condition. The company has adopted several significant accounting policies and is required to make significant accounting estimates that are important to understanding its financial statements. These significant policies and estimates are described throughout Item 8 - Notes to the Consolidated Financial Statements.

Although there are numerous areas in which Nicor’s management makes significant accounting estimates, it believes its critical estimates are those that require management’s most difficult and subjective or complex judgments. Nicor’s management has a practice of reviewing its critical 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, income taxes, credit risk, unbilled revenues and regulatory assets and liabilities because they are estimates which could materially impact Nicor’s financial statements.

Loss contingencies. Nicor and its subsidiaries record 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 and its subsidiaries and affiliates are involved in various legal and regulatory proceedings and are 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 21 - 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 11 - 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.

The company’s estimated postretirement benefit cost included in operating income was $5.5 million, $9.6 million and $9.1 million in 2006, 2005 and 2004, respectively. Nicor Gas expects to record postretirement benefit cost for 2007 of $4.6 million. Actuarial assumptions affecting 2007 include an expected rate of return on plan assets of 8.50 percent, consistent with the prior year, and a discount rate of 5.75 percent compared with 5.50 percent a year earlier. The 5.75 percent discount rate was based upon the Citigroup Pension Liability Index whose underlying average benefit duration approximates Nicor’s.

Income taxes. A deferred income tax liability is not recorded on undistributed foreign earnings that are expected in management’s judgment to be indefinitely reinvested offshore. Nicor has remaining at December 31, 2006 approximately $12 million of deferred income tax liabilities related to approximately $34 million of cumulative undistributed earnings of its foreign subsidiaries. Nicor has not recorded deferred income taxes of approximately $28 million on approximately $81 million of cumulative undistributed foreign earnings that are expected in management’s judgment to be indefinitely reinvested offshore. Changes in management’s investment or repatriation plans or circumstances could result in a different deferred income tax liability.

Credit risk. Nicor’s subsidiaries and affiliates are required to estimate credit risk in establishing allowances for doubtful accounts and in estimating the fair values of certain derivative instruments with counterparty credit risk being an especially difficult and critical judgment. Actual credit losses could vary materially from Nicor’s estimates. Nicor’s allowance for doubtful accounts at December 31, 2006, 2005 and 2004 was $33.4 million, $31.5 million and $21.9 million, respectively, as presented on Schedule II in Item 15 - Exhibits and Financial Statement Schedules.

Unbilled revenues. Nicor Gas estimates revenues for natural gas deliveries not yet billed to customers from the last billing date to month-end (“unbilled revenues”). Unbilled revenue estimates are dependent upon a number of customer-usage factors which require management judgment, including weather factors. These revenue estimates are adjusted when actual billings occur, and variances in estimates can 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, FASB Staff Position No. AUG AIR-1, Accounting for Planned Major Maintenance Activities, 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 and its subsidiaries and affiliates. Although Nicor 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 and other fuel 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; tourism and construction in the Bahamas and Caribbean region; 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.

Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this filing. Nicor undertakes no obligation to publicly release any revision to these forward-looking statements to reflect events or circumstances after the date of this filing.

Item 7A.    Quantitative and Qualitative Disclosures about Market Risk

Nicor is exposed to market risk in the normal course of its business operations, including the risk of loss arising from adverse changes in natural gas and fuel commodity prices, and interest rates. It is Nicor’s practice to manage these risks utilizing derivative instruments and other methods, as deemed appropriate.

Commodity price risk. With regard to commodity price risk, the company has established policies and procedures governing the management of such risks and the use of derivative instruments to hedge its exposure to such risks. Company management oversees compliance with such policies and procedures. The company utilizes various techniques to limit, measure and monitor market risk, including limits based on volume, dollar amounts, maturity, and in some cases value at risk (“VaR”).

VaR is the potential loss for an instrument or portfolio from adverse changes in market factors, for a specified time period and at a specified confidence level. The company has established exposure limits at such a level that material adverse economic results are not expected. The company’s commodity price risk policies and procedures continue to evolve with its businesses and are subject to ongoing review and modification.

In accordance with SEC disclosure requirements, Nicor performs sensitivity analyses to assess the potential loss in earnings based upon a hypothetical 10 percent adverse change in market prices. Management does not believe that sensitivity analyses alone provide an accurate or reliable method for monitoring and controlling risks and therefore also relies on the experience and judgment of its management to revise strategies and adjust positions as deemed necessary. Losses in excess of the amounts determined in sensitivity analyses could occur if market prices exceed the 10 percent shift used for the analyses.

As a regulated utility, Nicor Gas’ exposure to market risk caused by changes in commodity prices is substantially mitigated because of Illinois rate regulation allowing for the recovery of prudently incurred natural gas supply costs from customers. However, substantial changes in natural gas prices may impact

Nicor Gas’ earnings by increasing or decreasing the cost of gas used by the company, storage-related gas costs, bad debt expense, and other operating and financing expenses. The company purchases about 4 Bcf of natural gas annually for its own use and to cover storage-related gas costs. The level of natural gas prices may also impact customer gas consumption and therefore gas distribution margin. The actual impact of natural gas price fluctuations on Nicor Gas’ earnings is dependent upon several factors, including the company’s hedging practices. At December 31, 2006, Nicor Gas had hedged its forecasted 2007 and a portion of its 2008 company use and storage-related gas costs through the use of fixed-price purchase and swap agreements.

Nicor’s other energy businesses are subject to natural gas commodity price risk, arising primarily from purchase and sale agreements, transportation agreements, natural gas inventories and utility-bill management contracts. Derivative instruments such as futures, options, forwards and swaps may be used to hedge these risks. Based on Nicor’s other energy businesses unhedged positions at December 31, 2006, a 10 percent adverse change in natural gas prices would have decreased Nicor’s earnings for the periods ended December 31, 2006 and 2005 by about $0.4 million and $1.0 million, respectively.

At December 31, 2006, Nicor Enerchange, Nicor’s wholesale natural gas marketing business, held derivative contracts with the following asset (liability) fair values, net (in millions):

       
Maturity
 
 
Source of Fair Value
 
Total
Fair Value
 
Less than
1 Year
 
1 to 3
Years
 
3 to 5
Years
 
                           
Prices actively quoted
 
$
2.1
 
$
2.2
 
$
(.1
)
$
-
 
Prices based on pricing models
   
.2
   
.2
   
-
   
-
 
Total
 
$
2.3
 
$
2.4
 
$
(.1
)
$
-
 

Tropical Shipping’s objective is to substantially mitigate its exposure to higher fuel costs through fuel surcharges.

Credit risk. The company has a diversified customer base, which limits its exposure to concentrations of credit risk in any one industry or income class and believes that it maintains prudent credit policies. Additionally, the gas distribution segment offers options to help customers manage their bills, such as energy assistance programs for low-income customers and a budget payment plan that spreads gas bills more evenly throughout the year.

The company is also exposed to credit risk in the event a counterparty, customer or supplier defaults on a contract to pay for or deliver product at agreed-upon terms and conditions. To manage this risk, the company has established procedures to determine and monitor the creditworthiness of counterparties, to require guarantees or collateral back-up, and to limit its exposure to any one counterparty. The company also, in some instances, enters into netting arrangements to mitigate counterparty credit risk.

Interest rate risk. Nicor is exposed to changes in interest rates. The company manages its interest rate risk by issuing primarily fixed-rate long-term debt with varying maturities, refinancing certain debt and, at times, hedging the interest rate on anticipated borrowings. If market rates were to hypothetically increase by 10 percent from Nicor’s weighted-average floating interest rate on commercial paper, interest expense would have increased causing Nicor’s earnings to decrease by approximately $0.5 million in 2006. For further information about debt securities, interest rates and fair values, see Item 8 - Financial Statements - Consolidated Statements of Capitalization, and Item 8 - Notes to the Consolidated Financial Statements - Note 7 - Short-Term and Long-Term Debt and Note 9 - Fair Value of Financial Instruments.

Nicor Inc.
 
Item 8.   Financial Statements and Supplementary Data
   
Page
     
37
     
Financial Statements:
 
     
 
39
     
 
40
     
 
41
     
 
42
     
 
43
     
 
43
     
 
44

 








REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
To the Board of Directors and Stockholders of Nicor Inc.
 
We have audited the accompanying consolidated balance sheets and statements of capitalization of Nicor Inc. and subsidiaries (the “Company”) as of December 31, 2006 and 2005, and the related consolidated statements of operations, common equity, comprehensive income and cash flows for each of the three years in the period ended December 31, 2006.  Our audits also included the financial statement schedule listed in the Index at Item 15(a)(2).  We also have audited management's assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that the Company maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.  The Company's management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting.  Our responsibility is to express an opinion on these financial statements and financial statement schedule, an opinion on management's assessment, and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects.  Our audit of financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation.  Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances.  We believe that our audits provide a reasonable basis for our opinions.
 
A company's internal control over financial reporting is a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.  A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
 
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis.  Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM (concluded)

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2006 and 2005, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America.  Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. Also, in our opinion, management's assessment that the Company maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.  Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

As discussed in Note 2 to the consolidated financial statements, in 2006 the Company changed its method of accounting for defined benefit pension and other postretirement plans, and its method of accounting for share based payments. As discussed in Note 5 to the consolidated financial statements, in 2005 the Company changed its method of accounting for conditional asset retirement obligations.
 
 
/s/ DELOITTE & TOUCHE LLP
 
Chicago, Illinois
February 23, 2007
 

 




 
Nicor Inc.
             
               
             
(millions, except per share data)
             
               
   
Year ended December 31
 
   
2006
 
2005
 
2004
 
Operating revenues
                   
Gas distribution (includes revenue taxes of $147.7,
                   
$156.4, and $143.5, respectively)
 
$
2,452.3
 
$
2,909.6
 
$
2,362.1
 
Shipping
   
398.3
   
378.5
   
310.7
 
Other energy ventures
   
215.9
   
157.0
   
155.3
 
Corporate and eliminations
   
(106.5
)
 
(87.3
)
 
(88.4
)
Total operating revenues
   
2,960.0
   
3,357.8
   
2,739.7
 
                     
Operating expenses
                   
Gas distribution
                   
Cost of gas
   
1,743.7
   
2,212.4
   
1,695.0
 
Operating and maintenance
   
268.5
   
254.8
   
234.9
 
Depreciation
   
160.1
   
154.5
   
148.8
 
Taxes, other than income taxes
   
163.0
   
171.0
   
158.5
 
Mercury-related costs (recoveries), net
   
(3.6
)
 
.4
   
-
 
Property sale gains
   
(3.3
)
 
(.4
)
 
(5.9
)
Shipping
   
350.8
   
338.1
   
279.1
 
Other energy ventures
   
189.3
   
142.9
   
136.0
 
Litigation charges (recoveries), net
   
10.0
   
(29.9
)
 
38.5
 
Other corporate expenses and eliminations
   
(121.0
)
 
(87.7
)
 
(82.9
)
Total operating expenses
   
2,757.5
   
3,156.1
   
2,602.0
 
                     
Operating income
   
202.5
   
201.7
   
137.7
 
Interest expense, net of amounts capitalized
   
49.1
   
46.8
   
41.2
 
Equity investment income, net
   
11.1
   
9.3
   
6.3
 
Interest income
   
9.0
   
6.0
   
2.3
 
Other income, net
   
.6
   
.8
   
.2
 
                     
Income before income taxes
   
174.1
   
171.0
   
105.3
 
Income tax expense, net of benefits
   
45.8
   
34.7
   
30.2
 
                     
Net income
 
$
128.3
 
$
136.3
 
$
75.1
 
                     
Average shares of common stock outstanding
                   
Basic
   
44.6
   
44.2
   
44.1
 
Diluted
   
44.7
   
44.4
   
44.3
 
                     
Earnings per average share of common stock
                   
Basic
 
$
2.88
 
$
3.08
 
$
1.71
 
Diluted
 
$
2.87
 
$
3.07
 
$
1.70
 
                     
The accompanying notes are an integral part of these statements.
                   
 
 
39

 
Nicor Inc.
             
               
             
(millions)
             
               
   
Year ended December 31
 
   
2006
 
2005
 
2004
 
Operating activities
                   
Net income
 
$
128.3
 
$
136.3
 
$
75.1
 
Adjustments to reconcile net income to net cash flow
                   
provided from operating activities:
                   
Depreciation
   
178.1
   
172.4
   
166.6
 
Deferred income tax expense (benefit)
   
(44.5
)
 
(102.1
)
 
27.3
 
Net (gain) loss on sale of property, plant and equipment
   
(3.3
)
 
.3
   
(5.8
)
Gain on sale of equity investment
   
(2.4
)
 
-
   
-
 
Changes in assets and liabilities:
                   
Receivables, less allowances
   
325.6
   
(305.9
)
 
(121.5
)
Gas in storage
   
75.3
   
(40.6
)
 
13.3
 
Deferred/accrued gas costs
   
(173.2
)
 
154.9
   
21.3
 
Pension benefits
   
26.6
   
(6.1
)
 
(4.4
)
Regulatory postretirement asset
   
(113.5
)
 
-
   
-
 
Other assets
   
21.1
   
13.9
   
(.9
)
Accounts payable
   
(93.7
)
 
155.3
   
124.1
 
Health care and other postretirement benefits
   
89.1
   
12.6
   
11.2
 
Other liabilities
   
53.8
   
9.2
   
9.0
 
Other items
   
(20.3
)