nicorincform10q033109.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 March 31, 2009

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 No.)

1844 Ferry Road
 
Naperville, Illinois 60563-9600
(630) 305-9500
(Address of principal executive offices) (Zip Code)
(Registrant’s telephone number, including area code)

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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes [   ]   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 April 24, 2009, were 45,214,530 shares.




 


Table of Contents

 
ii
 
       
Part I - Financial Information
   
       
Item 1.
   
       
  1  
       
  2  
 
 
   
  3  
 
 
   
  4  
       
Item 2.
20  
 
 
   
Item 3.
31  
       
Item 4.
31  
       
Part II - Other Information
   
       
Item 1.
33  
       
Item 2.
33  
       
Item 6.
34  
       
  35  
 
i
 


Glossary

ALJs.  Administrative Law Judges.

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 5,600 degree days per year for 2009 and 5,830 degree days per year for 2008.

EN Engineering.  EN Engineering, L.L.C., a 50-percent-owned joint venture that provides engineering and consulting services that was sold on March 31, 2009.

FASB.  Financial Accounting Standards Board.

FIN.  FASB Interpretation.

FSP.  FASB Staff Position.

GSA.  General Services Administration, a governmental agency of the United States.

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, serves commercial and industrial customers in the Chicago market area, 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 move connection services for other utilities 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.

ii
 


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.

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, a rate rider that passes natural gas costs directly through to customers without markup, subject to ICC review.

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
 
   
March 31
 
   
2009
   
2008
 
Operating revenues
         
   Gas distribution (includes revenue taxes of $74.7 and $80.3, respectively)
$ 984.0     $ 1,464.2  
   Shipping
  89.4       97.7  
   Other energy ventures
  77.1       70.2  
   Corporate and eliminations
  (39.7 )     (36.4 )
   Total operating revenues
  1,110.8       1,595.7  
                 
Operating expenses
             
   Gas distribution
             
     Cost of gas
  716.4       1,186.7  
     Operating and maintenance
  90.6       88.6  
     Depreciation
  44.4       42.8  
     Taxes, other than income taxes
  78.8       83.8  
   Shipping
  82.8       93.8  
   Other energy ventures
  74.5       69.2  
   Other corporate expenses and eliminations
  (36.6 )     (32.4 )
   Total operating expenses
  1,050.9       1,532.5  
                 
Operating income
  59.9       63.2  
Interest expense, net of amounts capitalized
  9.3       10.6  
Equity investment income, net
  11.7       1.5  
Interest income
  .6       1.3  
Other income, net
  .2       -  
Income before income taxes
  63.1       55.4  
Income tax expense, net of benefits
  19.3       14.0  
Net income
$ 43.8     $ 41.4  
                 
Average shares of common stock outstanding
             
Basic
    45.4       45.3  
Diluted
    45.4       45.3  
                 
Earnings per average share of common stock
             
Basic
  $ .97     $ .92  
Diluted
    .96       .91  
                 
Dividends declared per share of common stock
$ .465     $ .465  
                 
                 
The accompanying notes are an integral part of these statements.
             

1
 


Nicor Inc.
           
           
(millions)
           
   
Three months ended
 
   
March 31
 
   
2009
   
2008
 
             
Operating activities
           
   Net income
  $ 43.8     $ 41.4  
   Adjustments to reconcile net income to net cash flow provided from operating activities:
               
   Depreciation
    49.0       47.4  
   Deferred income tax expense (benefit)
    3.2       (1.5 )
   Gain on sale of equity investment
    (10.1 )     -  
   Changes in assets and liabilities:
               
       Receivables, less allowances
    99.3       (265.0 )
       Gas in storage
    188.1       113.6  
       Deferred/accrued gas costs
    (.5 )     13.0  
       Derivative instruments
    63.6       (97.1 )
       Margin accounts - derivative instruments
    (73.4 )     48.9  
       Other assets
    17.1       (25.3 )
       Accounts payable and customer credit balances and deposits
    (210.7 )     (88.3 )
       Temporary LIFO inventory liquidation
    197.1       559.0  
       Other liabilities
    (1.2 )     38.5  
   Other items
    6.8       13.7  
   Net cash flow provided from operating activities
    372.1       398.3  
                 
Investing activities
               
   Additions to property, plant & equipment
    (51.2 )     (46.5 )
   Proceeds from maturities of held-to-maturity securities
    .6       -  
   Net decrease in other short-term investments
    1.7       .6  
   Proceeds from sale of equity investment
    13.0       -  
   Other investing activities
    -       2.6  
   Net cash flow used for investing activities
    (35.9 )     (43.3 )
                 
Financing activities
               
   Repayments of long-term debt
    (50.0 )     -  
   Net repayments of commercial paper
    (255.9 )     (341.0 )
   Dividends paid
    (21.1 )     (21.1 )
   Borrowing against cash surrender value of life insurance policies
    3.4       -  
   Repayment of loan against cash surrender value of life insurance policies
    -       (11.2 )
   Other financing activities
    -       (.1 )
   Net cash flow used for financing activities
    (323.6 )     (373.4 )
                 
Net increase (decrease) in cash and cash equivalents
    12.6       (18.4 )
                 
Cash and cash equivalents, beginning of period
    26.0       42.8  
                 
Cash and cash equivalents, end of period
  $ 38.6     $ 24.4  
                 
                 
The accompanying notes are an integral part of these statements.
               

2
 


Nicor Inc.
                 
             
(millions)
                 
   
March 31
   
December 31
   
March 31
 
   
2009
   
2008
   
2008
 
Assets
                 
Current assets
                 
 Cash and cash equivalents
  $ 38.6     $ 26.0     $ 24.4  
 Short-term investments
    67.8       69.5       48.5  
     Receivables, less allowances of $52.8, $44.9 and $53.0, respectively
    590.8       690.1       906.5  
 Gas in storage
    20.4       208.5       40.4  
 Derivative instruments
    61.2       49.7       125.0  
 Margin accounts - derivative instruments
    191.4       134.4       8.5  
     Other
    128.1       160.7       94.2  
Total current assets
    1,098.3       1,338.9       1,247.5  
                         
Property, plant and equipment, at cost
                       
 Gas distribution
    4,488.6       4,460.6       4,305.5  
 Shipping
    322.9       315.1       311.6  
     Other
    27.5       26.7       23.8  
      4,839.0       4,802.4       4,640.9  
 Less accumulated depreciation
    1,969.5       1,943.8       1,881.3  
Total property, plant and equipment, net
    2,869.5       2,858.6       2,759.6  
                         
Pension benefits
    36.5       36.4       219.3  
Long-term investments
    130.2       136.8       142.6  
Other assets
    442.5       413.3       152.9  
                         
Total assets
  $ 4,577.0     $ 4,784.0     $ 4,521.9  
                         
Liabilities and Capitalization
                       
Current liabilities
                       
 Long-term debt due within one year
  $ -     $ 50.0     $ 125.0  
 Short-term debt
    484.0       739.9       28.0  
 Accounts payable
    259.4       411.3       441.2  
 Customer credit balances and deposits
    128.5       187.3       133.2  
 Temporary LIFO inventory liquidation
    197.1       -       559.0  
 Derivative instruments
    219.1       167.3       30.0  
     Other
    114.4       112.2       239.3  
Total current liabilities
    1,402.5       1,668.0       1,555.7  
                         
Deferred credits and other liabilities
                       
 Regulatory asset retirement cost liability
    763.2       751.7       730.4  
 Deferred income taxes
    399.8       400.0       402.8  
 Health care and other postretirement benefits
    197.0       196.6       185.4  
 Asset retirement obligation
    186.9       185.0       178.7  
     Other
    177.3       161.0       123.7  
Total deferred credits and other liabilities
    1,724.2       1,694.3       1,621.0  
                         
Commitments and contingencies
                       
                         
Capitalization
                       
 Long-term obligations
                       
   Long-term debt, net of unamortized discount
    448.1       448.0       372.8  
   Mandatorily redeemable preferred stock
    .6       .6       .6  
 Total long-term obligations
    448.7       448.6       373.4  
                         
 Common equity
                       
   Common stock
    113.0       113.0       112.8  
   Paid-in capital
    51.4       49.5       45.9  
   Retained earnings
    852.9       830.3       815.8  
   Accumulated other comprehensive loss, net
    (15.7 )     (19.7 )     (2.7 )
 Total common equity
    1,001.6       973.1       971.8  
                         
Total capitalization
    1,450.3       1,421.7       1,345.2  
                         
Total liabilities and capitalization
  $ 4,577.0     $ 4,784.0     $ 4,521.9  
                         
                         
The accompanying notes are an integral part of these statements.
                 

3
 


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 2008 Annual Report on Form 10-K.

The information furnished reflects, in the opinion of the company, all adjustments (consisting only of normal recurring adjustments) 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.  The inventory decrement as of March 31, 2009 is expected to be restored prior to year-end.

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 2009, Nicor Enerchange recorded a charge of $2.8 million in the first quarter 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, or probable future expenditures.  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.
 
4
 


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

   
March 31
   
December 31
   
March 31
 
   
2009
   
2008
   
2008
 
Regulatory assets
                 
Regulatory postretirement asset – current
  $ 23.3     $ 23.3     $ 5.2  
Regulatory postretirement asset – noncurrent
    227.5       232.3       63.1  
Deferred gas costs – current
    15.4       31.5       -  
Deferred gas costs – noncurrent
    39.1       22.5       -  
Deferred environmental costs
    15.0       19.5       7.0  
Unamortized losses on reacquired debt
    15.1       15.4       16.2  
Other
    14.7       6.2       3.4  
    $ 350.1     $ 350.7     $ 94.9  

Regulatory liabilities
                 
Regulatory asset retirement cost liability – current
  $ 15.0     $ 15.0     $ 8.0  
Regulatory asset retirement cost liability – noncurrent
    763.2       751.7       730.4  
Accrued gas costs
    -       -       63.1  
Regulatory income tax liability
    45.5       46.3       48.8  
Other
    .8       .8       4.5  
    $ 824.5     $ 813.8     $ 854.8  

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 and accrued gas costs are classified in current liabilities – other.  All other regulatory liabilities are 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 postretirement asset is expected to be recovered from ratepayers over a period of approximately 10 to 13 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.  Nicor Gas is allowed to recover and is required to pay, using short-term interest rates, the carrying costs related to temporary under or overcollections of natural gas costs and certain environmental costs charged to its customers.

Goodwill.  Tropical Shipping had goodwill of $19.0 million, $19.0 million and $15.6 million at March 31, 2009, December 31, 2008 and March 31, 2008, respectively.  The increase in goodwill since March 31, 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 months ended March 31, 2009 and 2008 were $73.6 million and $78.9 million, respectively.

Derivative instruments.  Cash flows from derivative instruments are recognized in the Condensed Consolidated Statements of Cash Flows, and gains and losses are recognized in the Condensed Consolidated Statements of Operations, in the same categories as the underlying transactions.

Cash flow hedge accounting may be elected under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, only for highly effective hedges, based upon an assessment, performed at least quarterly, of the historical and probable future correlation of cash flows from the derivative instrument to
 
5

 
changes in the expected future cash flows of the hedged item.  To the extent cash flow hedge accounting is applied, the effective portion of any changes in the fair value of the derivative instruments is reported as a component of accumulated other comprehensive income.  Ineffectiveness, if any, is immediately recognized in operating income.  The amount in accumulated other comprehensive income is reclassified to earnings when the forecasted transaction occurs, even if the derivative instrument is sold, extinguished or terminated prior to the transaction occurring.  If the forecasted transaction is no longer expected to occur, the amount in accumulated other comprehensive income is immediately reclassified to earnings.

Nicor Gas.  Derivative instruments, such as futures contracts, options and swap agreements, are utilized primarily in the purchase of natural gas for customers.  These derivative instruments are reflected at fair value.  Realized gains or losses on such instruments are included in the cost of gas delivered and are passed directly through to customers, subject to ICC review, and therefore have no direct impact on earnings.  Unrealized changes in the fair value of these derivative instruments are deferred as regulatory assets or liabilities and classified on the balance sheet as deferred or accrued gas costs, respectively.

At times, Nicor Gas enters into futures contracts, options, swap agreements and fixed-price purchase agreements to reduce the earnings volatility of certain forecasted operating costs arising from fluctuations in natural gas prices, such as the purchase of natural gas for use in company operations.  These derivative instruments are carried at fair value, unless they qualify for the normal purchases and normal sales exception, in which case they are carried at cost.  To the extent hedge accounting is not elected, changes in such fair values are immediately recorded in current period earnings as operating and maintenance expense.

Nicor Enerchange.  Derivative instruments, such as futures contracts, options, forward contracts, swap agreements and other energy-related contracts are held by Nicor’s wholesale natural gas marketing business, Nicor Enerchange, for trading purposes.  Certain of these derivative instruments are used to economically hedge price risk associated with inventories of natural gas, fixed-price purchase and sale agreements and other future natural gas commitments.  Nicor Enerchange records such derivative instruments at fair value and generally does not elect hedge accounting.  As a result, changes in derivative fair values may have a material impact on Nicor’s financial statements.  Other derivative instruments are used by Nicor Enerchange to hedge price risks related to certain utility-bill management products.  These derivative instruments are carried at fair value and cash flow hedge accounting may or may not be elected.

Nicor Inc.  For derivative instruments that were designated as hedges of interest payments on 30-year bonds issued by Nicor Gas in December 2003, the amount deferred in accumulated other comprehensive income is being amortized to interest expense on a straight-line basis over the remaining life of the bonds.

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.  In 2008, 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 pertained 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, in its entirety, was not material to Nicor’s results of operations or financial condition.

6

 
4.
SHORT-TERM AND LONG-TERM DEBT

In February 2009, the $50 million 5.37 percent First Mortgage Bond series matured and was retired.

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 $484.0 million, $739.9 million and $28.0 million of commercial paper borrowings outstanding at March 31, 2009, December 31, 2008 and March 31, 2008, respectively.

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

5.         INCOME TAXES

The effective income tax rate for the three months ended March 31, 2009 increased to 30.6 percent from 25.3 percent in the prior-year period.  The higher effective income tax rate for the three months ended March 31, 2009 is due primarily to higher forecasted annual pretax income (which causes a higher effective income tax rate since permanent differences and tax credits are a smaller share of pretax income), lower forecasted annual undistributed foreign earnings and lower forecasted tax credits.

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 months ended March 31, 2009 and 2008, income tax expense has not been provided on approximately $5 million and $1 million, respectively, of foreign company shipping earnings that are expected to be indefinitely reinvested offshore.  As of March 31, 2009, Nicor has not recorded deferred income taxes of approximately $53 million on approximately $151 million of cumulative undistributed foreign earnings that are expected in management’s judgment to be indefinitely reinvested offshore.

The company has approximately $6 million of net interest receivable accrued at March 31, 2009 compared with $9 million of interest receivable as of December 31, 2008.  The change is due primarily to the settlement of interest in the first quarter of 2009 related to a state income tax matter.

The balance of unamortized investment tax credits at March 31, 2009, December 31, 2008 and March 31, 2008 was $25.4 million, $26.0 million and $26.9 million, respectively.

6.         ACCRUED UNBILLED REVENUES

Receivables include accrued unbilled revenues of $89.7 million, $199.1 million and $237.0 million at March 31, 2009, December 31, 2008 and March 31, 2008, 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.

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7.         FAIR VALUE MEASUREMENTS

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 tables below categorize those fair values across the three levels (in millions):
   
Fair value amount
 
   
Quoted prices in active markets
   
Significant observable inputs
   
Significant unobservable inputs
       
   
(Level 1)
   
(Level 2)
   
(Level 3)
   
Total
 
March 31, 2009
 
Assets
 
Money market funds
  $ 90.2     $ -     $ -     $ 90.2  
Derivatives
    35.1       20.4       17.0       72.5  
Total
  $ 125.3     $ 20.4     $ 17.0     $ 162.7  
   
Liabilities
 
Derivatives
  $ 225.1     $ 42.0     $ 1.3     $ 268.4  

December 31, 2008
     
Assets
 
Money market funds
  $ 81.2     $ -     $ -     $ 81.2  
Derivatives
    33.8       21.7       8.5       64.0  
Total
  $ 115.0     $ 21.7     $ 8.5     $ 145.2  
   
Liabilities
 
Derivatives
  $ 161.4     $ 28.0     $ 6.9     $ 196.3  

March 31, 2008
                       
Assets
                       
Money market funds
  $ 63.1     $ -     $ -     $ 63.1  
Derivatives
    81.3       35.8       11.0       128.1  
Total
  $ 144.4     $ 35.8     $ 11.0     $ 191.2  
                                 
Liabilities
 
Derivatives
  $ 20.7     $ 7.7     $ 1.7     $ 30.1  

When available and appropriate, the company uses quoted market prices in active markets to determine fair value, and classifies such items within Level 1.  For commodity derivatives, Level 1 values include only those 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.

8


Money market funds held by domestic subsidiaries are included in cash equivalents, whereas such funds held by non-U.S. subsidiaries are included in short-term investments.

The following table presents a reconciliation of the Level 3 beginning and ending net derivative asset balances for the three months ended March 31 (in millions):
 
   
2009
   
2008
 
             
Beginning of Period
  $ 1.6     $ 8.2  
Net realized/unrealized gains (losses)
               
Included in regulatory assets and liabilities
    (.1 )     5.9  
Included in net income
    9.4       2.5  
Settlements, net of purchases
    1.1       (7.2 )
Transfers in and/or out of Level 3
    3.7       (.1 )
End of period
  $ 15.7     $ 9.3  
                 
Net realized/unrealized gains (losses) included in net income relating to derivatives still held at March 31
  $ 9.3     $ 2.5  
                 
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.  The company’s policy is not to offset the fair value of assets and liabilities recognized for derivative instruments or any related margin account.  The following table represents the balances of margin accounts related to derivative instruments (in millions):
 
   
March 31
   
December 31
   
March 31
 
   
2009
   
2008
   
2008
 
Assets
                 
Margin accounts – derivative instruments
  $ 191.4     $ 134.4     $ 8.5  
Other – noncurrent
    45.7       29.3       -  
                         
Liabilities
                       
Other – current
  $ -     $ .1     $ 28.6  

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 March 31, 2009 was $450 million and at December 31, 2008 and March 31, 2008 was $500 million.  Based on quoted market interest rates, the fair value of the company’s First Mortgage Bonds outstanding was approximately $453 million at March 31, 2009, $520 million at December 31, 2008 and $510 million at March 31, 2008.
 
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8.
DERIVATIVE INSTRUMENTS

A description of the company’s objectives and strategies for using derivative instruments, and related accounting policies, is included in Note 2 – Accounting Policies – Derivative instruments.  All derivatives recognized on the Condensed Consolidated Balance Sheets are measured at fair value, as described in Note 7 – Fair Value Measurements.

Balance sheet.  Derivative assets and liabilities as of March 31, 2009, carried at fair value on the Condensed Consolidated Balance Sheets, are shown in the table below (in millions):

 
Asset derivatives
 
Liability derivatives
 
 
Location
 
Fair value
 
Location
 
Fair value
 
                 
Commodity derivatives designated as hedging instruments under SFAS No. 133
 
Current
Derivative instruments
  $ -  
Derivative instruments
  $ 6.1  
Noncurrent
Other
    -  
Other
    .5  
Total
  $ -       $ 6.6  
                     
Commodity derivatives not designated as hedging instruments under SFAS No. 133
 
Current
Derivative instruments
  $ 61.2  
Derivative instruments
  $ 213.0  
Noncurrent
Other
    11.3  
Other
    48.8  
Total
  $ 72.5       $ 261.8  

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.

Volumes.  As of March 31, 2009, Nicor Gas held outstanding derivative contracts of approximately 75 Bcf to hedge natural gas purchases for customer use, with hedges spanning approximately three years.  Commodity price-risk exposure arising from Nicor Enerchange’s activities and Nicor Gas’ natural gas purchases for company use is mitigated with derivative instruments that total to a net long position of 0.4 Bcf as of March 31, 2009.  The above volumes exclude contracts such as variable-priced contracts and basis swaps, which are accounted for as derivatives but are not directly impacted by changes in commodity prices.  

Income statement cash flow hedges.  Derivatives designated as a cash flow hedge relate to purchases of natural gas for Nicor Gas company use, risk management activities associated with the utility-bill management products, and hedges of anticipated fixed-rate debt issuances.  For the three months ended March 31, 2009, cash flow hedges affected accumulated other comprehensive income and income as shown in the following table (in millions):

 
Cash flow hedging relationships
 
Pretax gain (loss) recognized in other comprehensive income
(Effective portion)
 
Location
 
Pretax gain
(loss) reclassified from accumulated other comprehensive income into income
(Effective portion)
   
Pretax gain (loss) recognized in income
(Ineffective portion)
 
                     
Commodity contracts – Nicor Gas
  $
(3.9)
 
Operating and maintenance
  $
( 4.5)
    $
  -
 
                           
Commodity contracts – other energy ventures
   
(2.6)
 
Operating revenues
   
 (8.3)
     
  .2
 
                           
Interest rate contracts
   
   -
 
Interest expense
   
   (.1)
     
   -
 
Total
  $
(6.5)
      $
(12.9)
    $
  .2
 
                           
As of March 31, 2009, the time horizon of cash flow hedges for Nicor Gas company use and utility-bill management products sold by Nicor’s other energy ventures extends to as long as 20 months.  For these hedges, the total pretax loss deferred in accumulated other comprehensive income at March 31, 2009 was $7.1 million (or $4.3 million after taxes), of which $6.6 million (or $4.0 million after taxes) is expected to be reclassified to earnings within the next 12 months.  For interest rate hedges, the amounts deferred in accumulated other comprehensive income are being amortized to interest expense on a straight-line basis over the remaining life of the hedged bonds.  The total pretax loss deferred in accumulated other comprehensive income at March 31, 2009, was $6.0 million (or $3.6 million after taxes), of which $0.2 million (or $0.1 million after taxes) is expected to be reclassified to earnings within the next 12 months.

Income statement – derivatives not designated as hedges.  The earnings of the company are subject to volatility to the extent that derivatives used by the company’s other energy ventures, to hedge energy trading activities and utility-bill management products, and by Nicor Gas, to purchase gas for company use, are not designated as hedging instruments.  For the three months ended March 31, 2009, these pretax earnings effects are summarized in the table below (in millions):
       
Derivatives not designated as hedging
instruments under SFAS No. 133
 
Location
 
Net gain (loss) recognized in income
 
           
Commodity contracts  other energy ventures
 
Operating revenues
  $ (.8 )
Commodity contracts  Nicor Gas
 
Operating and maintenance
    (1.7 )
        $ (2.5 )

Nicor Gas’ derivatives to hedge the purchase of natural gas for its customers are also not designated as hedging instruments.  Gains or losses on these derivatives are deferred as regulatory assets or liabilities until the related revenue is recognized.  Net losses of $117.1 million were recognized in regulatory assets for the three months ended March 31, 2009.
 
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Credit-risk-related contingent features.  Provisions within certain derivative agreements require the company to post collateral if the company’s net liability position exceeds a specified threshold.  Also, certain derivative agreements contain credit-risk-related contingent features, whereby the company would be required to provide additional collateral or pay the amount due to the counterparty when a credit event occurs, such as if the company’s credit rating was to be lowered.  As of March 31, 2009, for agreements with such features, derivative contracts with liability fair values totaled approximately $38 million, for which the company had posted no collateral to its counterparties.  If it was assumed that the company had to post the maximum contractually specified collateral or settle the liability, the company would have been required to pay approximately $37 million.

Concentrations of credit risk.  In instances in which the company holds an uncollateralized net asset per an over-the-counter derivative contract, there is potential credit risk in the event the counterparty defaults on a settlement or fails to perform under the agreed-upon terms.  To manage this credit risk, the company maintains prudent credit policies to determine and monitor the creditworthiness of counterparties, seeks guarantees or collateral, in the form of cash or letters of credit, acquires credit insurance in certain instances and limits its exposure to any one counterparty.  The company also, in some instances, enters into netting arrangements to mitigate counterparty credit risk.

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 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 a limit 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.  As a regulated utility, Nicor Gas expects continued rate recovery of the eligible costs of its defined benefit postretirement plans and, accordingly, associated changes in the plan’s funded status have been deferred as a regulatory asset or liability until recognized in net income, instead of being recorded in accumulated other comprehensive income.  However, 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 and the changes in the funded status relating to these employees are recorded in accumulated other comprehensive income.

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
 
   
2009
   
2008
   
2009
   
2008
 
Three months ended March 31
                       
Service cost
  $ 2.2     $ 2.1     $ .6     $ .5  
Interest cost
    4.1       4.0       3.0       3.0  
Expected return on plan assets
    (6.3 )     (10.0 )     -       -  
Recognized net actuarial loss
    3.8       -       1.1       1.2  
Amortization of prior service cost
    .1       .1       -       -  
Net periodic benefit cost (credit)
  $ 3.9     $ (3.8 )   $ 4.7     $ 4.7  
                                 

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Due to the significant decline in the fair value of the pension plan’s assets during 2008, the expected return on plan assets has decreased in 2009 as compared to 2008.  Also, the fair value decline in 2008 has created an actuarial loss that is being amortized over the average remaining service lives of employees covered by the plan.

10.
EQUITY INVESTMENT INCOME, NET

On March 31, 2009, the company sold its 50-percent interest in EN Engineering.  The company’s share of the sale price is $16.0 million, with an additional $1.5 million which is contingent on EN Engineering’s 2010 performance and would be due in 2011.  After closing costs and other adjustments, Nicor received cash of $13.0 million and recorded a gain on the sale of $10.1 million.  Equity investment income also includes investment income from Triton of $1.2 million and $1.0 million for the three months ended March 31, 2009 and 2008, respectively.  Nicor received cash distributions from equity investees for the three months ended March 31, 2009 and 2008 of $2.8 million and $3.3 million, respectively.

11.
COMPREHENSIVE INCOME

Total comprehensive income is as follows (in millions):

   
Three months ended
 
   
March 31
 
   
2009
   
2008
 
             
Net income
  $ 43.8     $ 41.4  
Other comprehensive income, after tax
    4.0       5.2  
Total comprehensive income
  $ 47.8     $ 46.6  
 
Other comprehensive income 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.
 
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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 March 31, 2009
                         
Operating revenues
                             
External customers
  $ 964.8     $ 89.4     $ 56.6     $ -     $ 1,110.8  
Intersegment
    19.2       -       20.5       (39.7 )     -  
    $ 984.0     $ 89.4     $ 77.1     $ (39.7 )   $ 1,110.8  
                                         
Operating income (loss)
  $ 53.8     $ 6.6     $ 2.6     $ (3.1 )   $ 59.9  
                                         
Three months ended March 31, 2008
                                 
Operating revenues
                                       
External customers
  $ 1,432.7     $ 97.7     $ 65.3     $ -     $ 1,595.7  
Intersegment
    31.5       -       4.9       (36.4 )     -  
    $ 1,464.2     $ 97.7     $ 70.2     $ (36.4 )   $ 1,595.7  
                                         
Operating income (loss)
  $ 62.3     $ 3.9     $ 1.0     $ (4.0 )   $ 63.2  
                                         
The majority of intersegment revenues represent 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.

Costs associated with Nicor’s other energy ventures’ utility-bill management contracts attributable to colder than normal weather for the three months ended March 31, 2009 and 2008 were $2.6 million and $3.8 million, respectively.  This 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.  The company sought a revenue increase of $140.4 million for a rate of return on rate base of 9.27 percent, which reflects an 11.15 percent cost of common equity. The increase is needed to recover higher operating costs and increased capital investments.

In its rate filing, Nicor Gas proposed some new rate adjustment mechanisms.  These included 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 were 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.
 
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On March 25, 2009, the ICC issued an order approving an increase in base revenues of $69.0 million, a rate of return on rate base of 7.58 percent and a rate of return on equity of 10.17 percent.  The order also approved an energy efficiency rider.  Nicor Gas placed its new rates into effect on April 3, 2009.

On April 24, 2009, the company filed a request for rehearing with the ICC to appeal the capital structure and return on equity contained in the ICC’s rate order contending the company’s return on rate base should be higher.  The Attorney General’s office, Citizen’s Utility Board and the Environmental Law and Policy Center also filed requests for rehearing on items including the management structure of the Energy Efficiency Plan and the rate design for residential customers.  These other parties do not raise issues about the amount of the rate increase granted to Nicor Gas.  The ICC has until May 14, 2009 to either grant or deny the requests for rehearing.  Any further changes in rates as a result of rehearing would be effective prospectively.

14.
GUARANTEES AND INDEMNITIES

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

Financial guarantees.  TEL has an obligation 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 obligation continues for the life of the Triton partnerships and any payment is effectively limited to the assets of TEL, which were approximately $13 million at March 31, 2009.  Nicor believes the likelihood of any such payment by TEL is remote.  No liability has been recorded for this obligation.

Performance guarantees.  Nicor Services markets separately priced product warranty contracts that provide, over a period of one to fifteen years, 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 $1.9 million and $1.7 million were incurred in the three months ended March 31, 2009 and 2008, respectively.

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.  These indemnifications relate primarily to ongoing coal tar cleanup, as discussed in Note 15 – Contingencies – Manufactured Gas Plant Sites.  Nicor believes that the likelihood of payment under its other environmental indemnifications is remote.  No liability has been recorded for such 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.  In 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.
 
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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.

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
 
16

 
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 ALJs 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 ALJs 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.

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 March 31, 2009.

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.

As of March 31, 2009, Nicor Gas had remaining an estimated liability of $2.4 million related to inspection, cleanup 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.
 
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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.

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 cleanup of coal tar at certain former manufactured gas plant sites.

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 cleanup costs for 24 sites, no portion of the cleanup 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 March 31, 2009, the company had recorded a liability in connection with these matters of $20.1 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 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 cleanup 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 cleanup 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.  The company believes that the USEPA and the Illinois Attorney General have concluded their investigations and does not expect either agency to assess fines to, or pursue any enforcement actions, against Nicor Gas with respect to this matter.

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.  In April 2009, a purported class action lawsuit was filed against Nicor Gas in state court in Cook County, Illinois on behalf of customers who have been charged a municipal utility tax by the company but who are not residents of the taxing municipality.  The lawsuit asserts claims under the Illinois Consumer Fraud Act and the Illinois Public Utilities Act and for unjust enrichment, and seeks actual and punitive damages and an injunction.  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 2008 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
 
   
March 31
 
   
2009
   
2008
 
             
Net income
  $ 43.8     $ 41.4  
                 
Diluted earnings per common share
  $ .96     $ .91  

Comparisons of the three months ended results reflect lower operating income in the company’s gas distribution business and a higher effective income tax rate in 2009, partially offset by higher operating income in the company’s shipping and other energy-related businesses, higher corporate operating results and higher equity investment income.

Rate proceeding.  On April 29, 2008, Nicor Gas filed with the ICC for an overall increase in rates.  The company sought a revenue increase of $140.4 million for a rate of return on rate base of 9.27 percent, which reflects an 11.15 percent cost of common equity. The increase is needed to recover higher operating costs and increased capital investments.

In its rate filing, Nicor Gas proposed some new rate adjustment mechanisms.  These included 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 were 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.

On March 25, 2009, the ICC issued an order approving an increase in base revenues of $69.0 million, a rate of return on rate base of 7.58 percent and a rate of return on equity of 10.17 percent.  The order also approved an energy efficiency rider.  Nicor Gas placed its new rates into effect on April 3, 2009.  As a result of the new rates, it is estimated that a 100-degree day variation from normal (5,600 degree days annually) impacts Nicor Gas’ distribution margin, net of income taxes, by approximately $1.3 million.

On April 24, 2009, the company filed a request for rehearing with the ICC to appeal the capital structure and return on equity contained in the ICC’s rate order contending the company’s return on rate base should be higher.  The Attorney General’s office, Citizen’s Utility Board and the Environmental Law and Policy Center also filed requests for rehearing on items including the management structure of the Energy
 
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Efficiency Plan and the rate design for residential customers.  These other parties do not raise issues about the amount of the rate increase granted to Nicor Gas.  The ICC has until May 14, 2009 to either grant or deny the requests for rehearing.  Any further changes in rates as a result of rehearing would be effective prospectively.

Capital market environment.  The volatility in the capital markets during 2008 and 2009 has caused general concern over the valuations of investments, exposure to increased credit risk and pressures on liquidity.  The company has reviewed its investments, exposure to credit risk and sources of liquidity and does not currently expect any future material adverse impacts relating to these items.

The company sponsored defined benefit pension plan experienced significant declines in the market values of its investments in 2008.  These market value declines adversely impact the company’s future postretirement benefit costs in two ways.  First, the expected return on the pension plan’s assets (which serves to reduce postretirement benefit costs) declined as a result of the lower asset market values.  Second, the pension plan’s 2008 actuarial losses (largely due to the decline in asset market values) are being amortized over the average remaining service life of plan participants.  As a regulated utility, Nicor Gas expects continued rate recovery of the eligible costs of its defined benefit postretirement plans and, accordingly, associated changes in the plan’s funded status have been deferred as a regulatory asset or liability until recognized in net income, instead of being recorded in accumulated other comprehensive income.  The adverse impact of both factors on 2009 postretirement benefit costs compared to 2008 costs is approximately $30 million.  About one-fourth of this added cost will be capitalized as a cost of constructing gas distribution facilities and the remainder will be included in gas distribution operating and maintenance expense, net of any amounts charged to affiliates.  The company does not expect to make any contributions to the pension plan in 2009.  However, if market values of the pension plan assets continue to significantly decline, the company may be required to make future contributions.

Operating income by segment.  Operating income (loss) by major business segment is presented below (in millions):
   
Three months ended
 
   
March 31
 
   
2009
   
2008
 
             
Gas distribution
  $ 53.8     $ 62.3  
Shipping
    6.6       3.9  
Other energy ventures
    2.6       1.0  
Corporate and eliminations
    (3.1 )     (4.0 )
    $ 59.9     $ 63.2  

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

·  
Gas distribution operating income decreased $8.5 million for the three months ended March 31, 2009 compared to the prior year due primarily to lower gas distribution margin ($4.6 million decrease), higher operating and maintenance expense ($2.0 million increase) and higher depreciation expense ($1.6 million increase).

·  
Shipping operating income increased $2.7 million for the three months ended March 31, 2009 compared to the prior year due to lower operating costs ($11.0 million decrease), which were partially offset by lower operating revenues ($8.3 million decrease).   Operating costs were lower due primarily to lower transportation-related costs ($8.4 million decrease, largely attributable to lower fuel prices and lower volumes shipped), employee-related costs ($1.0 million decrease) and charter costs ($1.0 million decrease).  Operating revenues were lower due to lower volumes shipped ($11.0 million decrease), partially offset by higher average rates ($2.7 million increase).
 
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·  
Nicor’s other energy ventures operating income increased $1.6 million for the three months ended March 31, 2009 compared to the prior year due to higher operating income at Nicor’s wholesale natural gas marketing business, Nicor Enerchange ($4.5 million increase), partially offset by lower operating results at Nicor’s energy-related products and services businesses ($2.5 million decrease).  Higher operating income at Nicor Enerchange was due primarily to favorable changes in valuations of derivative instruments used to hedge purchases and sales of natural gas inventory and favorable costing of physical sales activity, partially offset by 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.  Lower operating results at Nicor’s energy-related products and services businesses were due to higher operating expenses ($4.8 million increase), partially offset by higher operating revenues ($2.3 million increase).

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, the changes in fair value are recorded in operating results in the period of change.  As a result, earnings are subject to volatility as the fair value of derivatives change.  The volatility resulting from this accounting can be significant from period to period.

·  
Corporate and eliminations operating results increased $0.9 million for the three months ended March 31, 2009 compared to the prior year due to lower costs of a natural weather hedge associated with the utility-bill management products offered by Nicor’s energy-related products and services businesses ($1.2 million decrease).  The company recorded $2.6 million of costs in the current year compared to $3.8 million of costs recorded in the prior year.  Benefits or costs resulting from variances from normal weather related to these products 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.
 
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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):

   
Three months ended
 
   
March 31
 
   
2009
   
2008
 
             
Gas distribution
  $ 984.0     $ 1,464.2  
Shipping
    89.4       97.7  
Other energy ventures
    77.1       70.2  
Corporate and eliminations
    (39.7 )     (36.4 )
    $ 1,110.8     $ 1,595.7  

Gas distribution revenues are impacted by changes in natural gas costs, which are passed directly through to customers without markup, subject to ICC review.  Gas distribution revenues decreased $480.2 million for the three months ended March 31, 2009 compared to the prior year due primarily to lower natural gas costs (approximately $365 million decrease), warmer weather (approximately $55 million decrease) and lower demand unrelated to weather (approximately $45 million decrease).

Shipping segment operating revenues decreased $8.3 million for the three months ended March 31, 2009 compared to the prior year due to lower volumes shipped ($11.0 million decrease), partially offset by higher average rates ($2.7 million increase).  Higher average rates were attributable to general rate increases, partially offset by lower cost-recovery surcharges for fuel.  Volumes shipped were adversely impacted by the economic slowdown.  During the second quarter of 2008, Tropical Shipping completed an acquisition of the assets of Caribtran, Inc., which is expected to add approximately 4 percent to expected shipping revenues on an annual basis.

Nicor’s other energy ventures operating revenues increased $6.9 million for the three months ended March 31, 2009 compared to the prior year due primarily to higher operating revenues at Nicor Enerchange ($4.5 million increase) and at Nicor’s energy-related products and services businesses ($2.3 million increase).  Higher operating revenues at Nicor Enerchange were due primarily to favorable changes in valuations of derivative instruments used to hedge purchases and sales of natural gas inventory and favorable costing of physical sales activity, partially offset by 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.  Higher operating revenues at Nicor’s energy-related products and services businesses were attributable to higher average contract volumes and higher average revenue per utility-bill management contract.

Corporate and eliminations reflects primarily the elimination of 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, with equal and offsetting fluctuations in cost of gas and revenue tax expense, with no direct impact on gas distribution margin.
 
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A reconciliation of gas distribution revenues and margin follows (in millions):

   
Three months ended
 
   
March 31
 
   
2009
   
2008
 
             
Gas distribution revenues
  $ 984.0     $ 1,464.2  
Cost of gas
    (716.4 )     (1,186.7 )
Revenue tax expense
    (73.6 )     (78.9 )
Gas distribution margin
  $ 194.0     $ 198.6  

Gas distribution margin decreased $4.6 million for the three months ended March 31, 2009 compared to the prior year due primarily to lower demand unrelated to weather (approximately $4 million decrease) and warmer weather (approximately $2 million decrease), partially offset by the impact of customer interest (approximately $3 million increase).

Gas distribution operating and maintenance expense.  Gas distribution operating and maintenance expense increased $2.0 million for the three months ended March 31, 2009 compared to the prior year due to higher payroll and benefit-related costs ($7.2 million increase, of which $5.4 million relates to higher pension expense, net of capitalization), partially offset by lower bad debt expense ($5.1 million decrease due to lower revenues attributable principally to lower natural gas prices).

Shipping operating expenses.  Shipping segment operating expenses decreased $11.0 million for the three months ended March 31, 2009 compared to the prior year due primarily to lower transportation-related costs ($8.4 million decrease, largely attributable to lower fuel prices and lower volumes shipped), employee-related costs ($1.0 million decrease) and charter costs ($1.0 million decrease).

Other energy ventures operating expenses.  Other energy ventures operating expenses increased $5.3 million for the three months ended March 31, 2009 compared to the prior year due primarily to an increase in operating expenses at Nicor’s energy-related products and services businesses ($4.8 million increase).  The increase in operating expenses at Nicor’s energy-related products and services businesses was due primarily to higher average contract volumes and higher average cost per utility-bill management contract.

Interest expense.  Interest expense decreased $1.3 million for the three months ended March 31, 2009 compared to the prior year due primarily to lower average interest rates, partially offset by higher average borrowing levels.

Net equity investment income.  Net equity investment income increased $10.2 million for the three months ended March 31, 2009 compared to the prior year.  On March 31, 2009, the company sold its 50-percent interest in EN Engineering and recognized a gain on the sale of $10.1 million.
 
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Interest income.  Interest income decreased $0.7 million for the three months ended March 31, 2009 compared to the prior year due primarily to the impact of lower average interest rates, partially offset by higher average investment balances.

Income tax expense.  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 months ended March 31, 2009 and 2008, income tax expense has not been provided on approximately $5 million and $1 million, respectively, of foreign company shipping earnings that are expected to be indefinitely reinvested offshore.  As of March 31, 2009, Nicor has not recorded deferred income taxes of approximately $53 million on approximately $151 million of cumulative undistributed foreign earnings that are expected in managementR