nicorincform10q093008.htm


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

FORM 10-Q

[X]
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
 
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2008

or

[   ]
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
 
SECURITIES EXCHANGE ACT OF 1934


Commission File Number 1-7297
NICOR INC. 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)

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 whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in rule 12b-2 of the Exchange Act.

Large accelerated filer    [X]
Accelerated filer                     [   ]
   
Non-accelerated filer      [   ]
Smaller reporting company   [   ]

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.  Common stock, par value $2.50, outstanding at October 27, 2008, were 45,191,267 shares.





 
 

 

Table of Contents

   
ii
 
         
Part I - Financial Information
     
         
Item 1.
     
         
      1  
         
           
      2  
         
           
      3  
         
           
      4  
           
Item 2.
    18  
         
           
Item 3.
    30  
           
Item 4.
    30  
           
Part II - Other Information
       
           
Item 1.
    31  
           
Item 1A.
    31  
           
Item 2.
    31  
           
Item 6.
    32  
           
                           Signature
    33  
 
 


Glossary

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.

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

FASB.  Financial Accounting Standards Board.

FIN.  FASB Interpretation.

FSP.  FASB Staff Position.

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.

LIFO.  Last-in, first-out.

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

MMBtus.  Million British thermal units.

Nicor.  Nicor Inc., or the registrant.

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 regulated  wholly owned public utility business and one of the nation’s largest distributors of natural gas.

Nicor Services.  Nicor Energy Services Company, a wholly owned business that provides customer and prospect 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.

ii 


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

PCBs.  Polychlorinated Biphenyls.

PGA.  Purchased Gas Adjustment.

SEC.  The United States Securities and Exchange Commission.

SFAS.  Statement of Financial Accounting Standards.

TEL.  Tropic Equipment Leasing Inc., a wholly owned subsidiary of Nicor, holds the company’s interests in Triton.

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.

USEPA.  United States Environmental Protection Agency.
 
iii
 


Part I - FINANCIAL INFORMATION
                       
                           
Item 1.     Financial Statements                        
                           
Nicor Inc.
                       
                   
(millions, except per share data)
                       
     
Three months ended
   
Nine months ended
 
     
September 30
   
September 30
 
     
2008
   
2007
   
2008
   
2007
 
Operating revenues
                       
Gas distribution (includes revenue taxes of
                       
$14.6, $12.8, $131.6 and $114.0, respectively)
  $ 306.1     $ 238.9     $ 2,330.4     $ 1,878.7  
Shipping
    108.5       97.5       308.8       293.6  
Other energy ventures
    34.9       37.3       157.8       159.0  
Corporate and eliminations
    (9.2 )     (8.5 )     (61.2 )     (74.5 )
Total operating revenues
    440.3       365.2       2,735.8       2,256.8  
 
 
                               
Operating expenses
                               
Gas distribution
                               
Cost of gas
    180.0       118.4       1,762.9       1,348.4  
Operating and maintenance
    64.2       59.7       212.5       201.5  
Depreciation
    42.8       41.4       128.5       124.4  
Taxes, other than income taxes
    18.9       17.0       143.3       126.1  
Mercury-related recoveries, net
    -       -       -       (8.0 )
Property sale gains
    (.2 )     (1.2 )     (.2 )     (2.0 )
Shipping
    99.0       88.8       289.7       266.7  
Other energy ventures
    34.3       26.8       145.2       143.2  
Other corporate expenses and eliminations
    (8.0 )     (8.5 )     (59.2 )     (72.8 )
Total operating expenses
    431.0       342.4       2,622.7       2,127.5  
                                   
Operating income
    9.3       22.8       113.1       129.3  
Interest expense, net of amounts capitalized
    9.9       10.4       29.6       34.3  
Equity investment income, net
    2.9       2.4       7.2       4.4  
Interest income
    1.4       2.3       6.9       7.1  
Other income (expense), net
    (.1 )     -       .1       .2  
                                   
Income before income taxes
    3.6       17.1       97.7       106.7  
Income tax expense
    2.3       2.6       26.1       27.0  
                                   
Net income
  $ 1.3     $ 14.5     $ 71.6     $ 79.7  
                                   
Average shares of common stock outstanding
                               
   Basic
      45.3       45.2       45.3       45.1  
   Diluted
    45.4       45.3       45.4       45.2  
                                   
Earnings per average share of common stock
                               
   Basic
    $ .03     $ .32     $ 1.58     $ 1.77  
   Diluted
    .03       .32       1.58       1.76  
                                   
Dividends declared per share of common stock
  $ .465     $ .465     $ 1.395     $ 1.395  
                                   
                                   
The accompanying notes are an integral part of these statements.
                         

 


Nicor Inc.             
           
(millions)             
   
Nine months ended
 
   
September 30
 
   
2008
   
2007
 
         
* As Adjusted
 
Operating activities
           
   Net income
  $ 71.6     $ 79.7  
   Adjustments to reconcile net income to net cash flow
               
     provided from operating activities:
               
        Depreciation
    142.8       138.4  
        Deferred income tax benefit
    (10.3 )     (2.5 )
        Gain on sale of property, plant and equipment
    (.4 )     (1.8 )
        Changes in assets and liabilities:
               
           Receivables, less allowances
    277.3       267.1  
           Gas in storage
    (120.9 )     (59.1 )
           Deferred/accrued gas costs
    (84.0 )     4.6  
           Derivative instruments
    48.3       (46.4 )
           Margin accounts - derivative instruments
    (66.1 )     7.3  
           Other assets
    (62.1 )     (12.6 )
           Accounts payable and customer credit balances and deposits
    (16.3 )     17.1  
           Litigation charge
    -       (10.0 )
           Other liabilities
    (16.9 )     (19.6 )
        Other items
    (6.9 )     7.2  
   Net cash flow provided from operating activities
    156.1       369.4  
                 
Investing activities
               
   Additions to property, plant & equipment
    (172.5 )     (119.1 )
   Release of restricted short-term investments
    -       10.0  
   Purchases of held-to-maturity securities
    (1.1 )     (1.3 )
   Proceeds from sales or maturities of held-to-maturity securities
    3.1       2.1  
   Purchases of available-for-sale securities
    -       (156.7 )
   Proceeds from the sales of available-for-sale securities
    -       156.7  
   Net decrease (increase) in other short-term investments
    5.4       (23.9 )
   Net proceeds from sale of property, plant and equipment
    .5       1.8  
   Business acquisition, net of cash acquired
    (5.9 )     -  
   Other investing activities
    7.1       (1.7 )
   Net cash flow used for investing activities
    (163.4 )     (132.1 )
                 
Financing activities
               
   Proceeds from issuing long-term debt
    75.0       -  
   Disbursements to retire long-term debt
    (75.0 )     -  
   Net issuances (repayments) of commercial paper with maturities of
               
      90 days or less
    70.0       (188.0 )
   Dividends paid
    (63.3 )     (63.0 )
   Proceeds from exercise of stock options
    1.6       8.1  
   Repayment of loan against cash surrender value of life insurance policies
    (11.2 )     -  
   Other financing activities
    (1.0 )     .4  
   Net cash flow used for financing activities
    (3.9 )     (242.5 )
                 
Net decrease in cash and cash equivalents
    (11.2 )     (5.2 )
                 
Cash and cash equivalents, beginning of period
    42.8       41.1  
                 
Cash and cash equivalents, end of period
  $ 31.6     $ 35.9  
                 
*      Prior periods were adjusted due to the retrospective application of FSP No. FIN 39-1. See New Accounting Pronouncements footnote for further information.
 
                 
The accompanying notes are an integral part of these statements.
               

 


Nicor Inc.
                 
             
(millions)
                 
                     
     
September 30
   
December 31
   
September 30
 
     
2008
   
2007
   
2007
 
Assets
       
* As Adjusted
   
* As Adjusted
 
                     
Current assets
                 
 
Cash and cash equivalents
  $ 31.6     $ 42.8     $ 35.9  
 
Short-term investments, at cost which approximates market
    42.8       49.1       40.2  
 
Receivables, less allowances of $45.9, $35.1and $34.0, respectively
    365.4       641.5       280.2  
 
Gas in storage
    274.9       154.0       245.1  
 
Deferred income taxes
    48.4       37.5       34.6  
 
Derivative instruments
    45.6       28.4       27.4  
 
Margin accounts - derivative instruments
    94.9       28.8       37.8  
 
Other
    105.3       61.0       62.8  
Total current assets
    1,008.9       1,043.1       764.0  
                           
Property, plant and equipment, at cost
                       
 
Gas distribution
    4,411.2       4,279.7       4,234.9  
 
Shipping
    315.2       309.2       306.3  
 
Other
    25.4       22.8       22.1  
        4,751.8       4,611.7       4,563.3  
 
Less accumulated depreciation
    1,928.3       1,854.4       1,833.1  
Total property, plant and equipment, net
    2,823.5       2,757.3       2,730.2  
                           
Pension benefits
    227.1       215.5       169.9  
Long-term investments
    139.1       132.9       133.6  
Other assets
    171.2       122.5       162.1  
                           
Total assets
  $ 4,369.8     $ 4,271.3     $ 3,959.8  
                           
                           
Liabilities and Capitalization
                       
                           
Current liabilities
                       
 
Long-term debt due within one year
  $ 50.0     $ 75.0     $ 75.0  
 
Short-term debt
    439.0       369.0       162.0  
 
Accounts payable
    435.4       428.2       345.2  
 
Customer credit balances and deposits
    211.0       234.5       234.0  
 
Accrued gas costs
    -       50.1       54.6  
 
Derivative instruments
    93.8       28.3       52.7  
 
Other
    90.1       110.6       114.1  
Total current liabilities
    1,319.3       1,295.7       1,037.6  
                           
Deferred credits and other liabilities
                       
 
Regulatory asset retirement cost liability
    749.6       720.7       709.9  
 
Deferred income taxes
    400.8       400.4       396.4  
 
Health care and other postretirement benefits
    187.0       185.1       183.3  
 
Asset retirement obligation
    183.4       177.5       175.3  
 
Regulatory income tax liability
    47.7       49.5       51.4  
 
Unamortized investment tax credits
    26.5       27.5       28.1  
 
Other
    52.2       46.3       45.7  
Total deferred credits and other liabilities
    1,647.2       1,607.0       1,590.1  
                           
Commitments and contingencies
                       
                           
Capitalization
                       
 
Long-term obligations
                       
 
 Long-term debt, net of unamortized discount
    448.0       422.8       422.7  
 
 Mandatorily redeemable preferred stock
    .6       .6       .6  
 
Total long-term obligations
    448.6       423.4       423.3  
                           
 
Common equity
                       
 
 Common stock
    113.0       112.8       112.8  
 
 Paid-in capital
    48.8       44.8       44.4  
 
 Retained earnings
    803.7       795.5       761.1  
 
 Accumulated other comprehensive loss, net
    (10.8 )     (7.9 )     (9.5 )
 
Total common equity
    954.7       945.2       908.8  
                           
Total capitalization
    1,403.3       1,368.6       1,332.1  
                           
Total liabilities and capitalization
  $ 4,369.8     $ 4,271.3     $ 3,959.8  
                           
*
     Prior periods were adjusted due to the retrospective application of FSP No. FIN 39-1. See New Accounting Pronouncements footnote for further information.
 
                           
The accompanying notes are an integral part of these statements.
                 

 

 
Nicor Inc.

Notes to the Condensed Consolidated Financial Statements (Unaudited)

1.
BASIS OF PRESENTATION

The unaudited Condensed Consolidated Financial Statements of Nicor have been prepared by the company pursuant to the rules and regulations of the SEC.  Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to SEC rules and regulations.  The unaudited Condensed Consolidated Financial Statements and Notes should be read in conjunction with the financial statements and the notes thereto included in the company’s 2007 Annual Report on Form
10-K.

The information furnished reflects, in the opinion of the company, all adjustments (consisting only of normal recurring adjustments and adjustments to reflect the changes in accounting policy as described in Note 3 – New Accounting Pronouncements) necessary for a fair statement of the results for the interim periods presented.  Results for the interim periods presented are not necessarily indicative of the results to be expected for the full fiscal year due to seasonal and other factors.

2.
ACCOUNTING POLICIES

Gas in storage.  Gas distribution segment inventory is carried at cost on a LIFO basis.  Inventory decrements occurring during interim periods that are expected to be restored prior to year-end are charged to cost of gas at the estimated annual replacement cost, and the difference between this cost and the actual LIFO layer cost is recorded on the balance sheet as a current temporary LIFO liquidation.  Interim inventory decrements not expected to be restored prior to year-end are charged to cost of gas at the actual LIFO cost of the layers liquidated.

Nicor Enerchange inventory is carried at the lower of weighted-average cost or market (market is represented by the cash price per the close of business on the last trading day of the period).  In 2008, Nicor Enerchange recorded a charge of $6.7 million in the third quarter resulting from a lower of cost or market valuation. Nicor Enerchange also recorded a charge of $5.0 million in the second quarter of 2007 resulting from a lower of cost or market valuation.

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 requires 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 base rates, upon approval by the ICC.  Regulatory liabilities represent probable future reductions in revenues collected from ratepayers through a rate rider or base rates.  If Nicor Gas’ operations become no longer subject to the provisions of SFAS No. 71, a write-off of net regulatory liabilities would be required.

 
The company had regulatory assets and liabilities as follows (in millions):

   
September 30
   
December 31
   
September 30
 
   
2008
   
2007
   
2007
 
Regulatory assets
                 
Regulatory postretirement asset – current
  $ 5.2     $ 5.2     $ 8.8  
Regulatory postretirement asset – noncurrent
    60.7       64.2       101.0  
Deferred gas costs
    33.9       -       -  
Deferred environmental costs
    11.0       9.5       10.9  
Unamortized losses on reacquired debt
    15.6       16.5       16.8  
Deferred rate case costs
    4.9       2.6       2.7  
Other
    4.5       .1       1.1  
    $ 135.8     $ 98.1     $ 141.3  

Regulatory liabilities
                 
Regulatory asset retirement cost liability – current
  $ 8.0     $ 8.0     $ 8.0  
Regulatory asset retirement cost liability – noncurrent
    749.6       720.7       709.9  
Accrued gas costs
    -       50.1       54.6  
Regulatory income tax liability
    47.7       49.5       51.4  
Other
    .8       1.1       -  
    $ 806.1     $ 829.4     $ 823.9  

The current portion of the regulatory postretirement asset and the deferred gas costs are classified in current assets – other.  All other regulatory assets are classified in noncurrent other assets.  The current portion of the regulatory asset retirement cost liability is classified in current liabilities – other.  Regulatory liabilities – other is classified in noncurrent other liabilities.

The ICC does not presently allow Nicor Gas the opportunity to earn a return on its regulatory postretirement asset.  This regulatory asset is expected to be recovered from ratepayers over a period of approximately 10 to 15 years.  The regulatory assets related to debt are not included in rate base, but are recovered over the term of the debt through the rate of return authorized by the ICC.

Goodwill.  Tropical Shipping had goodwill of $18.8 million, $15.6 million and $15.6 million at September 30, 2008, December 31, 2007 and September 30, 2007, respectively.  The increase in goodwill from December 31, 2007 to September 30, 2008 is due to the acquisition of the assets of Caribtran, Inc., a provider of less-than-container load and full container load consolidation services from the United States to the Caribbean and Central America.

Revenue taxes.  Nicor Gas classifies revenue taxes billed to customers as operating revenues and related taxes incurred as operating expenses.  Revenue taxes included in operating expense for the three and nine months ended September 30, 2008 were $14.3 million and $129.3 million, respectively, and $12.6 million and $112.2 million, respectively, for the same periods ending September 30, 2007.

Mercury-related recoveries, net.  Mercury-related recoveries, net reflect the estimated costs, recoveries and reserve adjustments associated with the company’s mercury inspection and repair program.
 
5
 

 
3.
NEW ACCOUNTING PRONOUNCEMENTS

Fair value measurements.  Effective January 1, 2008, the company adopted SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a consistent framework for measuring fair value, and expands disclosure requirements about fair value measurements.  This Statement does not require any new fair value measurements, rather it provides guidance on how to perform fair value measurements as required or permitted under other accounting pronouncements. It also provides for immediate recognition of trade-date gains and losses related to certain derivative transactions whose fair value has been determined using unobservable market inputs.  Nicor elected the one-year deferral allowed by FSP SFAS 157-2, Effective Date of FASB Statement No. 157, for certain nonfinancial assets and liabilities.  As it applies to Nicor, the deferral pertains to fair value measurements for business combinations, impairment testing of goodwill and other intangible assets, as well as asset retirement obligations.  The effect of adopting SFAS No. 157 was not material to Nicor’s results of operations or financial condition.

Offsetting of amounts related to certain contracts.  Effective January 1, 2008, Nicor adopted FSP No. FIN 39-1, Amendment of FIN 39, Offsetting of Amounts Related to Certain Contracts.  This FSP amends FIN 39 to replace the terms “conditional contracts” and “exchange contracts” with the term “derivative instruments” as defined in SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities.  Also, this FSP provides guidance on whether the receivable or liability recognized upon payment or receipt of cash collateral in a master netting agreement must be offset against fair value amounts recognized for contracts that have been offset in the same master netting agreement.  Upon adoption of this FSP, the company elected not to offset fair value assets and liabilities recognized for derivative instruments.  As a result, any related cash collateral is not offset against the derivatives.

This FSP was required to be applied retrospectively to all prior periods.  As a result of the application of this FSP, the company’s Condensed Consolidated Balance Sheets line items increased (decreased) by the following amounts (in millions):
   
September 30 2008
   
December 31 2007
   
September 30 2007
 
Assets
                 
Receivables
  $ (44.6 )   $ (22.5 )   $ (22.8 )
Derivative instruments
    25.0       13.0       15.5  
Margin accounts – derivative instruments
    94.9       28.8       37.8  
Liabilities
                       
Derivative instruments
  $ 75.2     $ 19.3     $ 30.5  
Current other liabilities
    .1       -       -  

Defined benefit pension and other postretirement plans.  On December 31, 2006, Nicor adopted the recognition provisions of SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.  In addition, SFAS No. 158 requires Nicor to change its plan measurement date to match its fiscal year-end.  Such provision is effective for Nicor no later than December 31, 2008 and will be adopted prospectively at that time.  In accordance with SFAS No. 158, Nicor has elected to use a 15-month approach for transitioning from an October 1 measurement date to a December 31 measurement date.  An adjustment to retained earnings will be recorded on December 31, 2008 to account for the transition since the total impact will not be known until the December 31, 2008 actuarial valuation of the plan is complete.
 
6
 

 
4.
RESTRICTED SHORT-TERM INVESTMENTS

In July 2006, Nicor reached a tentative agreement with the staff of the Enforcement Division of the SEC in settlement of an anticipated civil action against the company for a payment of $10 million.  At that time, the company deposited $10 million in an escrow account pending review and final approval of the tentative settlement by the SEC commissioners.  The SEC commissioners approved the tentative settlement in March 2007.  A final judgment, dated April 30, 2007, was entered by a federal court approving the settlement and the funds held in escrow were released.

5.
SHORT-TERM AND LONG-TERM DEBT

In August 2008, Nicor Gas, through a private placement, issued $75 million First Mortgage Bonds at 6.25 percent, due in 2038.  Nicor Gas retired the $75 million 5.875 percent First Mortgage Bond series that became due in August 2008.

In August 2008, Nicor Gas established a $600 million, 9-month seasonal revolver, expiring May 2009, to replace the $400 million, 210-day seasonal revolver, which expired in May 2008.  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 $439 million, $369 million and $162 million of commercial paper borrowings outstanding at September 30, 2008, December 31, 2007 and September 30, 2007, respectively.

The company believes it is in compliance with all debt covenants.

6.         INCOME TAXES

The effective income tax rate for the three months ended September 30, 2008 increased to 64.9 percent from 15.2 percent for the prior-year period.  The effective income tax rate for the three months ended September 30, 2008 is higher than the expected annual effective income tax rate as it reflects the impact of a reduction in projected annual untaxed foreign shipping earnings identified in the quarter.  The effective income tax rate for the three months ended September 30, 2007 was lower than the annual effective income tax rate as it reflected a reduction in taxable foreign shipping earnings which was recognized in the third quarter of 2007.  Such matters have a disproportionate impact on the third quarter effective income tax rate as the income before income taxes is relatively low.  The effective income tax rate for the nine months ended September 30, 2008 increased to 26.8 percent from 25.3 percent for the prior-year period.  The higher effective income tax rate for the first nine months of 2008 reflects a decrease in projected untaxed foreign shipping earnings for 2008 and the absence of the reduction in taxable foreign earnings recognized in the third quarter of 2007, offset, in part, by tax reserve adjustments and lower projected 2008 annual pretax income (which causes a lower effective income tax rate since permanent differences and tax credits are a larger share of pretax income).

In 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 determined to be indefinitely reinvested offshore, no deferred income tax expense would be recorded by the company.  For the three and nine months ended September 30, 2008, income tax expense has not been provided on approximately $5 million and $8 million, respectively, of foreign company shipping earnings that are expected to be indefinitely reinvested offshore compared to approximately $6 million and $19 million, respectively, for the comparable periods in 2007.  As of September 30, 2008, Nicor has not recorded deferred income taxes of approximately $46 million on approximately $131 million of cumulative undistributed foreign earnings that are expected in management’s judgment to be indefinitely reinvested offshore.

 

 
The company’s liability for unrecognized tax benefits was $8.2 million at September 30, 2008 of which about $1 million, if recognized, would impact the company’s effective income tax rate.  The increase in unrecognized tax benefits from $5.7 million at December 31, 2007 is due primarily to an item concerning the timing of inclusion in taxable income of recoveries for environmental clean-up expenditures, partially offset by settlements and adjustments to estimates.  The company believes that it is reasonably possible that a change in its unrecognized tax benefits could occur within 12 months, potentially increasing by $7 million or decreasing by $13 million its unrecognized tax benefits.

The company has approximately $8 million of net interest receivable related to interest and penalties on tax matters at September 30, 2008 compared with approximately $8 million of net interest payable related to interest and penalties on tax matters at December 31, 2007.  The change is due primarily to an interest payment made in the second quarter of 2008.

7.
ACCRUED UNBILLED REVENUES

Receivables include accrued unbilled revenues of $52.0 million, $191.2 million and $57.4 million at September 30, 2008, December 31, 2007 and September 30, 2007, respectively, related primarily to gas distribution operations.  Nicor Gas accrues revenues for estimated deliveries to customers from the date of their last bill until the balance sheet date.

8.         FAIR VALUE

Effective January 1, 2008, SFAS No. 157, Fair Value Measurements, defines a three-level hierarchy which prioritizes the inputs to valuation techniques used to measure fair value into three broad levels, with Level 1 considered the most reliable.  For assets and liabilities measured at fair value on a recurring basis on the Condensed Consolidated Balance Sheets, the table below categorizes those fair values across the three levels as of September 30, 2008 (in millions):

   
Fair Value Amount
 
   
Quoted Prices in Active Markets
   
Significant Observable Inputs
   
Significant Unobservable Inputs
       
   
(Level 1)
   
(Level 2)
   
(Level 3)
   
Total
 
Assets
 
Commodity Derivatives:
 
Financial - current
  $ 23.0     $ 7.1     $ .8     $ 30.9  
Physical - current
    -       9.8       4.9       14.7  
Physical - noncurrent
    -       .1       1.8       1.9  
Total
  $ 23.0     $ 17.0     $ 7.5     $ 47.5  
                                 
Liabilities
 
Commodity Derivatives:
 
Financial - current
  $ 74.6     $ 11.2     $ 1.6     $ 87.4  
Financial - noncurrent
    -       1.0       -       1.0  
Physical - current
    -       2.7       3.7       6.4  
Physical - noncurrent
    -       -       .1       .1  
Total
  $ 74.6     $ 14.9     $ 5.4     $ 94.9  
 
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When available and appropriate, the company uses quoted market prices in active markets to determine fair value, and classifies such items within Level 1.  Level 1 values only include derivative instruments traded on the NYMEX.  The company enters into over-the-counter instruments with values that are similar to, and correlate with, quoted prices for exchange-traded instruments in active markets; these over-the-counter items are classified within Level 2.  In certain instances, the company may be required to use one or more significant unobservable inputs for a model-derived valuation; the resulting valuation is classified as Level 3.

The net fair value of commodity derivatives relates largely to Nicor Gas.  The majority of derivatives held by Nicor Gas are for the purpose of hedging natural gas purchases for its customers, and therefore their values do not affect net income, as their settlement is passed directly through to customers without markup, subject to ICC review.  The change in fair value for these derivatives is accounted for through regulatory assets and liabilities.

The current portions of the derivatives noted in the table on the previous page are stated separately within current assets and current liabilities on the Condensed Consolidated Balance Sheets.  The noncurrent portions of the derivatives are classified in noncurrent other.

The following table presents a reconciliation of the Level 3 beginning and ending net derivative asset balance for the periods ended September 30, 2008 (in millions):

   
Three months ended
   
Nine months ended
 
             
Beginning of Period
  $ 6.9     $ 8.2  
Net realized/unrealized gains (losses)
               
Included in regulatory assets and liabilities
    1.1       7.0  
Included in net income
    -       2.5  
Settlements, net of purchases
    (2.7 )     (10.9 )
Transfers in and/or out of Level 3
    (3.2 )     (4.7 )
End of period
  $ 2.1     $ 2.1  
                 
Net realized/unrealized gains (losses) included in net income relating to derivatives still held at September 30, 2008
  $ (1.1 )   $ 1.4  
                 
Net realized/unrealized gains (losses) included in net income are attributable to Nicor Enerchange and are classified as operating revenues.

Nicor maintains margin accounts related to financial derivative transactions.  As of September 30, 2008, Nicor Gas recorded $79.0 million and Nicor Enerchange recorded $15.9 million in margin accounts - derivative instruments within current assets on the Condensed Consolidated Balance Sheets. The company’s policy is not to offset fair value assets and liabilities recognized for derivative instruments or any related margin account.

The recorded amount of short-term investments, restricted short-term investments, and short-term borrowings approximates fair value.  Long-term debt outstanding, including current maturities, is recorded at the principal balance outstanding, net of unamortized discounts.  The principal balance of Nicor Gas’ First Mortgage Bonds outstanding at September 30, 2008, December 31, 2007 and September 30, 2007 was $500 million.  Based on quoted market interest rates, the fair value of the company’s First Mortgage Bonds outstanding was approximately $486 million at September 30, 2008, $513 million at December 31, 2007 and $508 million at September 30, 2007.
 
9
 

 
9.
POSTRETIREMENT BENEFITS

Nicor Gas maintains a noncontributory defined benefit pension plan covering substantially all employees hired prior to 1998.  Pension benefits are based on years of service and highest average salary for management employees and job level for collectively bargained employees.  The benefit obligation related to collectively bargained employee benefits considers the company’s past practice of regular benefit increases to reflect current wages.  Nicor Gas also provides health care and life insurance benefits to eligible retired employees under a plan that includes limits on the company’s share of cost for employees hired after 1982.  The company’s postretirement benefit costs have historically been considered in rate proceedings in the period they are accrued.  To the extent Nicor Gas employees perform services for non-regulated affiliates and to the extent such employees are eligible to participate in these plans, the affiliates are charged for the cost of these benefits.

About one-fourth of the net periodic benefit cost or credit related to these plans has been capitalized as a cost of constructing gas distribution facilities and the remainder is included in gas distribution operating and maintenance expense, net of amounts charged to affiliates.  Net periodic benefit cost (credit) included the following components (in millions):
 
   
Pension benefits
   
Health care and
other benefits
 
   
2008
   
2007
   
2008
   
2007
 
Three months ended September 30
                       
Service cost
  $ 2.1     $ 2.2     $ .6     $ .5  
Interest cost
    4.0       3.8       3.0       2.7  
Expected return on plan assets
    (9.9 )     (9.0 )     -       -  
Recognized net actuarial loss
    -       -       1.2       1.3  
Amortization of prior service cost
    .1       .1       (.1 )     (.1 )
Net periodic benefit cost (credit)
  $ (3.7 )   $ (2.9 )   $ 4.7     $ 4.4  
                                 
Nine months ended September 30
                               
Service cost
  $ 6.4     $ 6.8     $ 1.6     $ 1.7  
Interest cost
    11.9       11.3       9.0       8.1  
Expected return on plan assets
    (29.9 )     (27.0 )     -       -  
Recognized net actuarial loss
    -       -       3.5       3.6  
Amortization of prior service cost
    .3       .4       (.1 )     (.1 )
Net periodic benefit cost (credit)
  $ (11.3 )   $ (8.5 )   $ 14.0     $ 13.3  

10.
EQUITY INVESTMENT INCOME, NET

Net equity investment income includes investment income from Triton of $2.0 million and $5.2 million, respectively, for the three and nine months ended September 30, 2008 and $1.5 million and $3.7 million for the same periods ended September 30, 2007, respectively.  Nicor received cash distributions from equity investees for the three and nine months ended September 30, 2008 of $4.5 million and $11.8 million, respectively, and $2.6 million and $8.9 million, respectively, for the same periods ended September 30, 2007.
 
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11.
COMPREHENSIVE INCOME

Total comprehensive income is as follows (in millions):

   
Three months ended
   
Nine months ended
 
   
September 30
   
September 30
 
   
2008
   
2007
   
2008
   
2007
 
                         
Net income
  $ 1.3     $ 14.5     $ 71.6     $ 79.7  
Other comprehensive income (loss), after tax
    (12.1 )     (1.6 )     (2.9 )     3.8  
Total comprehensive income (loss)
  $ (10.8 )   $ 12.9     $ 68.7     $ 83.5  
 
Other comprehensive income (loss) consists primarily of net unrealized gains and losses from derivative financial instruments accounted for as cash flow hedges, including Nicor’s share of such amounts from joint ventures and other equity-method investees.

12.       BUSINESS SEGMENT INFORMATION

Financial data by major business segment is presented below (in millions):

   
Gas
distribution
   
 
Shipping
   
Other
energy
ventures
   
Corporate
and
eliminations
   
 
Consolidated
 
Three months ended September 30, 2008
                         
Operating revenues
                             
External customers
  $ 299.2     $ 108.5     $ 32.6     $ -     $ 440.3  
Intersegment
    6.9       -       2.3       (9.2 )     -  
    $ 306.1     $ 108.5     $ 34.9     $ (9.2 )   $ 440.3  
                                         
Operating income (loss)
  $ .4     $ 9.5     $ .6     $ (1.2 )   $ 9.3  
                                         
Three months ended September 30, 2007
                                 
Operating revenues
                                       
External customers
  $ 232.8     $ 97.5     $ 34.9     $ -     $ 365.2  
Intersegment
    6.1       -       2.4       (8.5 )     -  
    $ 238.9     $ 97.5     $ 37.3     $ (8.5 )   $ 365.2  
                                         
Operating income
  $ 3.6     $ 8.7     $ 10.5     $ -     $ 22.8  
                                         
Nine months ended September 30, 2008
                                 
Operating revenues
                                       
   External customers
  $ 2,275.2     $ 308.8     $ 151.8     $ -     $ 2,735.8  
   Intersegment
    55.2       -       6.0       (61.2 )     -  
    $ 2,330.4     $ 308.8     $ 157.8     $ (61.2 )   $ 2,735.8  
                                         
Operating income (loss)
  $ 83.4     $ 19.1     $ 12.6     $ (2.0 )   $ 113.1  
                                         
Nine months ended September 30, 2007
                                 
Operating revenues
                                       
   External customers
  $ 1,825.8     $ 293.6     $ 137.4     $ -     $ 2,256.8  
   Intersegment
    52.9       -       21.6       (74.5 )     -  
    $ 1,878.7     $ 293.6     $ 159.0     $ (74.5 )   $ 2,256.8  
                                         
        Operating income (loss)   88.3      26.9      15.8      (1.7    129.3   

11 
 

 
The majority of intersegment revenues represent gas distribution revenues related to customers entering into utility-bill management contracts with Nicor Solutions.  Under the utility-bill management contracts, Nicor Solutions bills a fixed amount to a customer, regardless of changes in natural gas prices or weather, and in exchange pays the customer’s utility bills from Nicor Gas.  Intersegment revenues are eliminated in the Condensed Consolidated Financial Statements.

Benefits (costs) associated with Nicor’s other energy ventures’ utility-bill management contracts attributable to warmer (colder) than normal weather for the three and nine months ended September 30, 2008 were $0.4 million and ($3.6) million, respectively, and $0.3 million and $0.2 million, respectively, for the same periods in 2007.  This benefit (cost) is recorded 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.

13.
RATE PROCEEDING

On April 29, 2008, Nicor Gas filed with the ICC for an overall increase in rates of $140.3 million.  The company’s filing provides for a rate of return on rate base of 9.21 percent, which reflects an 11.05 percent cost of common equity.  The requested rate increase is needed to recover higher operating costs and increased capital investments.

In its rate filing, Nicor Gas has proposed some new rate adjustment mechanisms.  These include mechanisms that would adjust rates to reflect certain changes in the company’s bad debt expense and cost of gas used for operations.  Also included are a volume balancing rider that would adjust rates to recover fixed costs, an energy efficiency rider that would fund energy efficiency programs and a rider that would adjust rates to recover a portion of capital expenditures incurred to replace certain older infrastructure.

The ICC normally has 11 months to complete its review of the filing and to issue an order.  The proposed rate increase has been suspended pending the completion of the ICC’s review.

On September 25, 2008, Nicor Gas filed rebuttal testimony with the ICC, in response to direct testimony of the ICC staff and intervenors in the proceeding, and revised its proposed rate increase to approximately $141.6 million. The revised proposal provides for a rate of return on rate base of 9.27 percent, which reflects an 11.15 percent cost of common equity.

14.
GUARANTEES AND INDEMNITIES

Nicor and certain subsidiaries enter into various financial and performance guarantees and indemnities providing assurance to third parties.

Financial guarantees.  The company has issued guarantees of affiliate obligations to vendors and other third parties, requiring Nicor to pay the obligations should its affiliates default.  The obligations of the company’s wholly owned subsidiaries are reflected in Nicor’s Condensed Consolidated Balance Sheets, while the obligations of its unconsolidated equity investments are not.

TEL has a contingent liability to restore to zero any deficit in its equity account for income tax purposes in the unlikely event that Triton is liquidated and a deficit balance remains.  This contingent liability continues for the life of the Triton partnerships and any payment is effectively limited to the assets of TEL, which were approximately $8 million at September 30, 2008.  Nicor believes the likelihood of any such payment by TEL is either remote, or the fair value of the indemnification was immaterial, and no liability has been recorded for this contingent liability.
 
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Performance guarantees.  Nicor Services markets separately priced product warranty contracts that provide for the repair of heating, ventilation and air conditioning equipment, natural gas lines, and other appliances within homes.  Revenues from these product warranty contracts are recognized ratably over the coverage period, and related repair costs are charged to expense as incurred.  Repair expenses of $1.6 million and $4.9 million were incurred in the three and nine months ended September 30, 2008, respectively, and $1.5 million and $4.7 million, respectively, for the same periods last year.

Indemnities.  In certain instances, Nicor has undertaken to indemnify current property owners and others against costs associated with the effects and/or remediation of contaminated sites for which the company may be responsible under applicable federal or state environmental laws, generally with no limitation as to the amount.  Aside from liabilities recorded in connection with coal tar clean-up, as discussed in Note 15 – Contingencies – Manufactured Gas Plant Sites, Nicor believes that the likelihood of payment under these indemnifications is either remote, or the fair value of the indemnification was immaterial, and no liability has been recorded for these indemnifications.

Nicor has also indemnified, to the fullest extent permitted under the laws of the State of Illinois and any other applicable laws, its present and former directors, officers and employees against expenses they may incur in connection with litigation they are a party to by reason of their association with the company.  There is generally no limitation as to the amount.  During 2007, the SEC filed a civil injunctive action against three former officers of Nicor relating to the PBR Plan.  Defense costs that are being incurred by these former officers in connection with the SEC action currently are being tendered to, and paid by, the company’s insurer.  While the company does not expect to incur significant costs relating to the indemnification of present and former directors, officers and employees after taking into account available insurance, it is not possible to estimate the maximum future potential payments.

15.
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 plan 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.
 
13
 

 
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.

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.  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.  In addition, interest due to the company on certain components of these amounts has not been recognized in the financial statements due to the same uncertainties.  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 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, Nicor Gas withdrew its previously filed testimony and the Administrative Law Judges issued a scheduling order that provided for Nicor Gas to submit direct testimony by April 13, 2007.  In its direct testimony filed pursuant to the scheduling order, Nicor Gas seeks a reimbursement of approximately $6 million, which includes interest due to the company as noted above of $1.6 million, as of March 31, 2007.  No date has been set for evidentiary hearings on this matter.

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In 2004, 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 September 30, 2008.

Mercury.  Nicor Gas has incurred, and expects to continue to incur, costs related to its historical use of mercury in various kinds of company equipment.

In the first quarter of 2007, Nicor Gas recorded a $7.2 million reduction to its previously established reserve for mercury-related matters.  The reduction was attributable primarily to the favorable settlement during that quarter of certain lawsuits that had been pending against Nicor Gas.  As of September 30, 2008, Nicor Gas had remaining an estimated liability of $2.1 million related to inspection, clean-up and legal defense costs.  This represents management’s best estimate of future costs based on an evaluation of currently available information.  Actual costs may vary from this estimate.

Nicor Gas remains a defendant in several private lawsuits, all in the Circuit Court of Cook County, Illinois, seeking a variety of unquantified damages (including bodily injury and property damages) allegedly caused by mercury spillage resulting from the removal of mercury-containing regulators.  Potential liabilities relating to these claims have been assumed by a contractor’s insurer subject to certain limitations.

Nicor Gas continues to pursue recovery from insurers and independent contractors that had performed work for the company.  In the first quarter of 2007, the company recorded a net recovery of approximately $0.8 million.

The final disposition of these mercury-related matters is not expected to have a material adverse impact on the company’s liquidity or financial condition.

Manufactured Gas Plant Sites.  Manufactured gas plants were used in the 1800’s and early to mid 1900’s to produce manufactured gas from coal, creating a coal tar byproduct.  Current environmental laws may require the clean-up of coal tar at certain former manufactured gas plant sites.
 
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To date, Nicor Gas has identified about 40 properties for which it may have some responsibility.  Most of these properties are not presently owned by the company.  Nicor Gas and Commonwealth Edison Company (“ComEd”) are parties to an interim agreement to cooperate in cleaning up residue at many of these properties.  Under the interim agreement, mutually agreed costs are to be evenly split between Nicor Gas and ComEd until such time as they are finally allocated either through negotiation or arbitration.  On April 17, 2006, Nicor Gas initiated arbitration to determine the final allocations of these costs between Nicor Gas and ComEd.  On January 3, 2008, Nicor Gas and ComEd entered into a definitive agreement concerning final cost allocations.  The definitive agreement allocates to Nicor Gas 51.73 percent of clean-up costs for 24 sites, no portion of the clean-up costs for 14 other sites and 50 percent of general remediation program costs that do not relate exclusively to particular sites.  The definitive agreement is subject, among other things, to approval by the ICC.  The arbitration that was initiated by Nicor Gas in 2006 currently is stayed pursuant to the arbitration panel’s order and is expected to be stayed pending the ICC review of the definitive allocation agreement.  Information regarding preliminary site reviews has been presented to the Illinois Environmental Protection Agency for certain properties.  More detailed investigations and remedial activities are complete, in progress or planned at many of these sites.  The results of the detailed site-by-site investigations will determine the extent additional remediation is necessary and provide a basis for estimating additional future costs.  As of September 30, 2008, the company had recorded a liability in connection with these matters of $11.9 million.  In accordance with ICC authorization, the company has been recovering, and expects to continue to recover, these costs from its customers, subject to annual prudence reviews.

In December 2001, a purported class action lawsuit was filed against Exelon Corporation, ComEd and Nicor Gas in the Circuit Court of Cook County alleging, among other things, that the clean-up of a former manufactured gas plant site in Oak Park, Illinois was inadequate.  Additional lawsuits were later filed related to this same former manufactured gas plant site.  These lawsuits sought, in part, unspecified damages for property damage, nuisance, and various personal injuries that allegedly resulted from exposure to contaminants allegedly emanating from the site, injunctive relief to compel the defendants to engage in various clean-up activities and punitive damages.  An agreement in principle to settle the purported class action was reached in the first quarter of 2006 at which time a $2.3 million reserve for this matter was recorded by the company.  The settlement was approved by the trial court and the lawsuit was dismissed during the second quarter of 2007.  Under the settlement, the company made a payment of $2.2 million which was charged against a previously established reserve.  The remaining lawsuits relating to the Oak Park site were settled and the claims dismissed during the first quarter of 2008.  In accordance with ICC authorization, the company expects to recover costs of such settlements from its customers, subject to an annual prudence review.

In April 2002, Nicor Gas was named as a defendant, together with ComEd, in a lawsuit brought by the Metropolitan Water Reclamation District of Greater Chicago (the “MWRDGC”) under the Federal Comprehensive Environmental Response, Compensation and Liability Act seeking recovery of past and future remediation costs and a declaration of the level of appropriate clean-up for a former manufactured gas plant site in Skokie, Illinois now owned by the MWRDGC.  In January 2003, the suit was amended to include a claim under the Federal Resource Conservation and Recovery Act.  The suit was filed in the United States District Court for the Northern District of Illinois.  Management cannot predict the outcome of this litigation or the company’s potential exposure thereto, if any, and has not recorded a liability associated with this contingency.

Since costs and recoveries relating to the clean-up of manufactured gas plant sites are passed directly through to customers in accordance with ICC regulations, subject to an annual ICC prudence review, the final disposition of manufactured gas plant matters is not expected to have a material impact on the company’s financial condition or results of operations.

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PCBs.  In June 2007, Nicor Gas notified the USEPA of the discovery by Nicor Gas of PCBs at four homes in Park Ridge, Illinois.  Nicor Gas has cleaned up the PCBs at these four homes.  In July 2007, the USEPA issued a subpoena to Nicor Gas pursuant to Section 11 of the Toxic Substances Control Act.  In the subpoena, the USEPA indicated that it was investigating Nicor Gas’ identification of PCB-contaminated liquids in its distribution system.  The subpoena sought documents related to Nicor Gas’ pipeline liquids and the extent and location of PCBs contained therein.  The Illinois Attorney General made a similar request for information from Nicor Gas.  Nicor Gas has provided documentation to the USEPA and the Illinois Attorney General, including information about the presence of PCBs in its system, and has conducted sample testing at additional customer locations.  While Nicor is unable to predict the outcome of these inquiries or to reasonably estimate its potential exposure related thereto, if any, and has not recorded a liability associated with this contingency, the final disposition of this matter is not expected to have a material adverse impact on the company’s liquidity or financial condition.

Municipal Tax Matters.  Many municipalities in Nicor Gas’ service territory have enacted ordinances that impose taxes on gas sales to customers within municipal boundaries.  Most of these municipal taxes are imposed on Nicor Gas based on revenues generated by Nicor Gas within the municipality.  Other municipal taxes are imposed on natural gas consumers within the municipality but are collected from consumers and remitted to the municipality by Nicor Gas.  A number of municipalities have instituted audits of Nicor Gas’ tax remittances.  In May 2007, five of those municipalities filed an action against Nicor Gas in state court in DuPage County, Illinois relating to these tax audits.  Following a dismissal of this action without prejudice by the trial court, the municipalities filed an amended complaint in August 2008.  The amended complaint seeks, among other things, compensation for alleged unpaid taxes.  Nicor Gas is contesting the claims in the amended complaint.  In December 2007, 25 additional municipalities, all represented by the same audit firm involved in the lawsuit, issued assessments to Nicor Gas claiming that it failed to provide information requested by the audit firm and owed the municipalities back taxes.  Nicor Gas believes the assessments are improper and has challenged them.  While the company is unable to predict the outcome of these matters or to reasonably estimate its potential exposure related thereto, if any, and has not recorded a liability associated with this contingency, the final disposition of these matters is not expected to have a material adverse impact on the company’s liquidity or financial condition.

Other.  In addition to the matters set forth above, the company is involved in legal or administrative proceedings before various courts and agencies with respect to general claims, taxes, environmental, gas cost prudence reviews and other matters.  Although unable to determine the ultimate outcome of these other contingencies, management believes that these amounts are appropriately reflected in the financial statements, including the recording of appropriate liabilities when reasonably estimable.
 
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Item 2.          Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the Management’s Discussion and Analysis section of the Nicor 2007 Annual Report on Form 10-K.  Results for the interim periods presented are not necessarily indicative of the results to be expected for the full fiscal year due to seasonal and other factors.

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 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):
 
   
Three months ended
   
Nine months ended
 
   
September 30
   
September 30
 
   
2008
   
2007
   
2008
   
2007
 
 
             
 
       
Net income
  $ 1.3     $ 14.5     $ 71.6     $ 79.7  
 
                               
Diluted earnings per common share
  $ .03     $ .32     $ 1.58     $ 1.76  

Net income and diluted earnings per common share for the nine months ended September 30, 2007 includes pretax mercury-related recoveries of $8.0 million ($.11 per share) associated with Nicor Gas’ mercury inspection and repair program which included a reduction of $7.2 million to the company’s previously established reserve and $0.8 million in cost recoveries.

Comparisons of the three months ended results reflect lower operating income in the company’s gas distribution and other energy-related businesses and lower corporate operating results, partially offset by higher operating income in the company’s shipping business.  Comparisons of the nine months ended results (excluding the effect of the mercury-related item noted above) reflect lower operating income in the company’s shipping and other energy-related businesses and lower corporate operating results, partially offset by higher operating income in the company’s gas distribution business.

Rate proceeding.  On April 29, 2008, Nicor Gas filed with the ICC for an overall increase in rates of $140.3 million.  The company’s filing provides for a rate of return on rate base of 9.21 percent, which reflects an 11.05 percent cost of common equity.  The requested rate increase is needed to recover higher operating costs and increased capital investments.

In its rate filing, Nicor Gas has proposed some new rate adjustment mechanisms.  These include mechanisms that would adjust rates to reflect certain changes in the company’s bad debt expense and cost of gas used for operations.  Also included are a volume balancing rider that would adjust rates to recover fixed costs, an energy efficiency rider that would fund energy efficiency programs and a rider that would adjust rates to recover a portion of capital expenditures incurred to replace certain older infrastructure.

The ICC normally has 11 months to complete its review of the filing and to issue an order.  The proposed rate increase has been suspended pending the completion of the ICC’s review.

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On September 25, 2008, Nicor Gas filed rebuttal testimony with the ICC, in response to direct testimony of the ICC staff and intervenors in the proceeding, and revised its proposed rate increase to approximately $141.6 million. The revised proposal provides for a rate of return on rate base of 9.27 percent, which reflects an 11.15 percent cost of common equity.

Capital market environment.  The recent volatility in the capital markets has caused general concern over the valuations of investments, exposure to increased credit risk and pressures on liquidity.  To date, the company has not incurred, for financial statement purposes, any material adverse impacts due to these market conditions.  However, if market values of certain investments of the company’s defined benefit pension plan do not recover during the fourth quarter of 2008, the company’s net periodic benefit costs will be adversely impacted in 2009 and beyond.  The company has reviewed its investments, exposure to credit risk and sources of liquidity and, with the exception of the potential impact on future net periodic benefit costs, does not currently expect any future material adverse impacts relating to these items.

Operating income by segment.  Operating income (loss) by major business segment is presented below (in millions):

   
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September 30
   
September 30
 
   
2008
   
2007
   
2008
   
2007
 
 
 
 
 
 
 
 
         
 
Gas distribution
  $ .4     $ 3.6     $ 83.4     $ 88.3  
Shipping
    9.5       8.7       19.1       26.9  
Other energy ventures
    .6       10.5       12.6       15.8  
Corporate and eliminations
    (1.2 )     -       (2.0 )     (1.7 )
    $ 9.3     $ 22.8     $ 113.1     $ 129.3  

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

·  
Gas distribution operating income decreased $3.2 million for the three months ended September 30, 2008 compared to the prior-year period due primarily to higher operating and maintenance expense ($4.5 million increase), depreciation expense ($1.4 million increase) and lower gains on property sales ($1.0 million decrease), partially offset by higher gas distribution margin ($3.9 million increase).

Operating income decreased $4.9 million for the nine months ended September 30, 2008 compared to the prior-year period due primarily to higher operating and maintenance expense ($11.0 million increase), the absence of mercury-related recoveries recorded during the first quarter of 2007 ($8.0 million decrease), higher depreciation expense ($4.1 million increase) and lower gains on property sales ($1.8 million decrease), partially offset by higher gas distribution margin ($20.1 million increase).

·  
Shipping operating income increased $0.8 million for the three months ended September 30, 2008 compared to the prior-year period due to higher operating revenues ($11.0 million increase), which were partially offset by higher operating costs ($10.2 million increase).   Operating revenues were higher due to higher average rates ($13.8 million increase), partially offset by lower volumes shipped ($2.8 million decrease).  Operating costs were higher due primarily to increased transportation-related costs ($9.3 million increase) attributable primarily to increased fuel costs.
 
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Operating income decreased $7.8 million for the nine months ended September 30, 2008 compared to the prior-year period due to higher operating revenues ($15.2 million increase) which were more than offset by higher operating costs ($23.0 million increase).  Operating revenues were higher due to higher average rates ($26.6 million increase), partially offset by lower volumes shipped ($11.4 million decrease).  Operating costs were higher due primarily to increased transportation-related costs ($21.0 million increase) attributable primarily to increased fuel costs.

·  
Nicor’s other energy ventures operating income decreased $9.9 million for the three months ended September 30, 2008 compared to the prior-year period due primarily to lower operating results at Nicor’s wholesale natural gas marketing business, Nicor Enerchange ($7.1 million decrease), and lower operating income at Nicor’s energy-related products and services businesses ($2.6 million decrease).  Lower operating results at Nicor Enerchange were due to unfavorable costing of physical sales activity and lower results from the company's risk management activities associated with hedging the product risks of the utility-bill management contracts offered by Nicor's energy-related products and services businesses, partially offset by favorable changes in valuations of derivative instruments used to hedge purchases and sales of natural gas inventory.  Lower operating results at Nicor's energy-related products and services businesses were due to higher operating expenses ($1.8 million increase) and lower operating revenues ($0.8 million decrease).

Operating income decreased $3.2 million for the nine months ended September 30, 2008 compared to the prior-year period due primarily to lower operating income at Nicor Enerchange ($8.5 million decrease), partially offset by higher operating income at Nicor’s energy-related products and services businesses ($5.8 million increase).  Lower operating income at Nicor Enerchange was due primarily to unfavorable changes in valuations of derivative instruments used to hedge purchases and sales of natural gas inventory and lower results from the company’s risk management activities associated with hedging the product risks of the utility-bill management contracts offered by Nicor’s energy-related products and services businesses, partially offset by the favorable costing of physical sales activity.  Improved results at Nicor’s energy-related products and services business were due to lower operating expenses ($15.9 million decrease), partially offset by lower operating revenues ($10.1 million decrease).

Nicor Enerchange uses derivatives to mitigate commodity price risk in order to substantially lock-in the profit margin that will ultimately be realized.  A source of commodity price risk arises as Nicor Enerchange purchases and holds natural gas in storage to earn a profit margin from its ultimate sale.  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 carried at fair value, with changes in fair value recorded in operating results in the period of change.  In addition, Nicor Enerchange also uses derivatives to mitigate the commodity price risks of the utility-bill management products offered by Nicor’s energy-related products and services businesses.  The gains and losses associated with the utility-bill management products are recognized in the months that the services are provided. However, the underlying derivatives used to hedge the price exposure are carried at fair value. For those derivatives that don’t meet the requirements for hedge accounting