**UNITED
        STATES**
 **SECURITIES
        AND EXCHANGE COMMISSION**
 Washington,
        D.C. 20549
 
 **FORM
        10-Q**
 
 [X]
              QUARTERLY
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES
                  EXCHANGE ACT OF 1934
 
 **For
        the quarterly period ended September 30, 2006**
 
 or
 
 [
                  ]
              TRANSITION
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES
                  EXCHANGE ACT OF 1934
 
 
 Commission
        File Number 1-7296
 
 
 **NORTHERN
        ILLINOIS GAS COMPANY**
 **(Doing
        business as Nicor Gas Company)**
 (Exact
        name of registrant as specified in its charter)
 
 
 **Illinois**
              **36-2863847**(State
                  of Incorporation)
              (I.R.S.
                  EmployerIdentification
                  Number)
 
 **1844
                  Ferry Road****Naperville,
                  Illinois 60563-9600**
              **(630)
                  983-8888**(Address
                  of principal executive offices)
              (Registrant’s
                  telephone number)
 
 The
        registrant meets the conditions set forth in General Instruction H(1)(a)
        and (b)
        of Form 10-Q and is therefore filing this Form with the reduced disclosure
        format.
 
 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, or a non-accelerated filer. See definition of “accelerated
        filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
        one):
 Large
                  accelerated filer [ ]
              Accelerated
                  filer [ ]
              Non-accelerated
                  filer [X]
 
 Indicate
        by check mark whether the registrant is a shell company (as defined in Rule
        12b-2 of the Exchange Act). Yes [ ] No [X]
 
 All
        shares of common stock are owned by Nicor Inc.
 
 
  
  **Table
        of Contents**
 
 **Glossary**
              
              ii**Part
                  I - Financial Information**Item
                  1.
              Financial
                  Statements - (Unaudited)Condensed
                  Consolidated Statements of
                  Operations:
              1Three
                  and nine months endedSeptember
                  30, 2006 and 2005Condensed
                  Consolidated Statements of Cash
                  Flows:
              2Nine
                  months endedSeptember
                  30, 2006 and 2005Condensed
                  Consolidated Balance
                  Sheets:
              3September
                  30, 2006 and 2005, andDecember
                  31, 2005Notes
                  to the Condensed Consolidated Financial
                  Statements
              4Item
                  2.
              Management’s
                  Discussion and Analysis of
                  Financial Condition and Results of Operations
              17Item
                  3.
              Quantitative
                  and Qualitative Disclosures About Market
                  Risk
              26Item
                  4.
              Controls
                  and Procedures
              26**Part
                  II - Other Information**Item
                  1.
              Legal
                  Proceedings
              26Item
                  6.
              Exhibits
              27Signature
              28
 
 
 
 
 
 
 
 i
  Table
            of Contents
  **Glossary**
 
 **Chicago
        Hub.** A
        venture
        of Northern Illinois Gas Company, doing business as Nicor Gas Company (“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 of Nicor that provides engineering and corrosion
        services.
 
 **FERC.** Federal
        Energy Regulatory Commission, the agency that regulates the interstate
        transportation of natural gas, oil and electricity.
 
 **Horizon
        Pipeline.** Horizon
        Pipeline Company, L.L.C., a 50-percent-owned joint venture of Nicor that
        operates an interstate regulated natural gas pipeline of approximately 70
        miles,
        stretching from Joliet, Illinois to near the Wisconsin/Illinois
        border.
 
 **ICC.** Illinois
        Commerce Commission, the agency that establishes the rules and regulations
        governing utility rates and services in Illinois.
 
 **Mcf,
        MMcf, Bcf.** Thousand
        cubic feet, million cubic feet, billion cubic feet.
 
 **Nicor
        Enerchange.** Nicor
        Enerchange, L.L.C., a wholly owned business of Nicor Inc. that engages in
        wholesale marketing of natural gas supply services primarily in the Midwest,
        administers the Chicago Hub for Nicor Gas, and manages Nicor’s other energy
        ventures’ product risks.
 
 **Nicor.** Nicor
        Inc., parent company of Nicor Gas.
 
 **Nicor
        Solutions.** Nicor
        Solutions, L.L.C., a wholly owned business of Nicor that offers residential
        and
        small commercial customers energy-related products that provide for natural
        gas
        cost stability and management of their utility bill.
 
 **PBR.** Performance-based
        rate, a regulatory plan which ended on January 1, 2003, that provided economic
        incentives based on natural gas cost performance.
 
 
  
 
 ii








Table
          of Contents


**PART
                I - FINANCIAL
                INFORMATION****Item
                1. Financial Statements****Nicor
                Gas Company****Condensed
                Consolidated Statements of Operations (Unaudited)****(millions)****Three
                months ended**
            
            **Nine
                months ended****September
                30**
            
            **September
                30****2006**
            
            2005
            
            **2006**
            
            2005Operating
                revenues (includes revenue taxesof
                $12.9, $12.8, $111.5 and $112.4, respectively)
            
            **$**
            **226.7**
            
            $
            241.5
            
            **$**
            **1,775.6**
            
            $
            1,692.6Operating
                expensesCost
                of gas
            
            
            **108.0**
            
            
            134.9
            
            
            **1,258.8**
            
            
            1,202.3Operating
                and maintenance
            
            
            **56.4**
            
            
            50.9
            
            
            **199.2**
            
            
            177.6Depreciation
            
            
            **40.1**
            
            
            38.6
            
            
            **120.3**
            
            
            115.9Taxes,
                other than income taxes
            
            
            **17.0**
            
            
            16.6
            
            
            **123.2**
            
            
            124.0Income
                tax expense (benefit), net
            
            
            **(2.0**
            **)**
            
            (3.4
            )
            
            **14.5**
            
            
            14.0Mercury-related
                costs (recoveries), net
            
            
            **-**
            
            
            .1
            
            
            **(3.6**
            **)**
            
            .3**219.5**
            
            
            237.7
            
            
            **1,712.4**
            
            
            1,634.1Operating
                income
            
            
            **7.2**
            
            
            3.8
            
            
            **63.2**
            
            
            58.5Other
                income (expense), netProperty
                sale gains
            
            
            **.6**
            
            
            .1
            
            
            **3.2**
            
            
            .2Interest
                income
            
            
            **2.1**
            
            
            1.5
            
            
            **6.0**
            
            
            3.9Other
                income (expense), net
            
            
            **-**
            
            
            -
            
            
            **(.3**
            **)**
            
            (.4
            )Income
                taxes on other income
            
            
            **(1.2**
            **)**
            
            (.6
            )
            
            **(3.8**
            **)**
            
            (1.4
            )**1.5**
            
            
            1.0
            
            
            **5.1**
            
            
            2.3Interest
                expenseInterest
                on debt, net of amounts capitalized
            
            
            **8.2**
            
            
            8.5
            
            
            **27.5**
            
            
            26.3Other
            
            
            **2.1**
            
            
            1.7
            
            
            **4.0**
            
            
            3.9**10.3**
            
            
            10.2
            
            
            **31.5**
            
            
            30.2Net
                income (loss)
            
            **$**
            **(1.6**
            **)**
            $
            (5.4
            )
            **$**
            **36.8**
            
            $
            30.6The
                accompanying notes are an integral part of these
                statements.




1


Table
          of Contents


**Nicor
                Gas Company****Condensed
                Consolidated Statements of Cash Flows (Unaudited)****(millions)****Nine
                months ended****September
                30****2006**
            
            2005Operating
                activitiesNet
                income
            
            **$**
            **36.8**
            
            $
            30.6Adjustments
                to reconcile net income to net cash flowprovided
                from operating activities:Depreciation
            
            
            **120.3**
            
            
            115.9Deferred
                income tax benefit
            
            
            **(38.6**
            **)**
            
            (56.1
            )Gain
                on sale of property, plant and equipment
            
            
            **(3.2**
            **)**
            
            (.2
            )Changes
                in assets and liabilities:Receivables,
                less allowances
            
            
            **521.9**
            
            
            315.7Gas
                in storage
            
            
            **39.0**
            
            
            (121.2
            )Deferred/accrued
                gas costs
            
            
            **(114.4**
            **)**
            
            217.4Prepaid
                pension costs
            
            
            **(7.4**
            **)**
            
            (4.6
            )Other
                assets
            
            
            **6.7**
            
            
            (90.4
            )Accounts
                payable
            
            
            **(112.0**
            **)**
            
            120.5Other
                liabilities
            
            
            **27.2**
            
            
            (20.4
            )Other
                items
            
            
            **(4.9**
            **)**
            
            2.4Net
                cash flow provided from operating activities
            
            
            **471.4**
            
            
            509.6Investing
                activitiesCapital
                expenditures
            
            
            **(114.4**
            **)**
            
            (136.8
            )Net
                proceeds from sale of property, plant and equipment
            
            
            **3.4**
            
            
            .3Other
                investing activities
            
            
            **4.6**
            
            
            -Net
                cash flow used for investing activities
            
            
            **(106.4**
            **)**
            
            (136.5
            )Financing
                activitiesDisbursements
                to retire long-term obligations
            
            
            **(.5**
            **)**
            
            (.5
            )Net
                repayments of commercial paper with maturities of90
                days or less
            
            
            **(339.0**
            **)**
            
            (344.0
            )Dividends
                paid
            
            
            **(35.0**
            **)**
            
            (28.0
            )Other
                financing activities
            
            
            **-**
            
            
            (.5
            )Net
                cash flow used for financing activities
            
            
            **(374.5**
            **)**
            
            (373.0
            )Net
                increase (decrease) in cash and cash equivalents
            
            
            **(9.5**
            **)**
            
            .1Cash
                and cash equivalents, beginning of period
            
            
            **10.2**
            
            
            -Cash
                and cash equivalents, end of period
            
            **$**
            **.7**
            
            $
            .1The
                accompanying notes are an integral part of these
                statements.




2




Table
          of Contents


**Nicor
                Gas Company****Condensed
                Consolidated Balance Sheets (Unaudited)****(millions)****September
                30**
            
            December
                31
            
            September
                30**2006**
            
            2005
            
            2005**Assets**Gas
                distribution plant, at cost
            
            **$**
            **4,118.6**
            
            $
            4,043.2
            
            $
            3,933.2Less
                accumulated depreciation
            
            
            **1,557.5**
            
            
            1,513.1
            
            
            1,462.4Gas
                distribution plant, net
            
            
            **2,561.1**
            
            
            2,530.1
            
            
            2,470.8Current
                assetsCash
                and cash equivalents
            
            
            **.7**
            
            
            10.2
            
            
            .1Receivables,
                less allowances of $32.4,$30.1
                and $25.2, respectively
            
            
            **241.9**
            
            
            753.0
            
            
            177.6Receivables
                - affiliates
            
            
            **7.7**
            
            
            18.5
            
            
            7.3Gas
                in storage, at last-in, first-out cost
            
            
            **182.0**
            
            
            221.0
            
            
            310.2Deferred
                income taxes
            
            
            **14.6**
            
            
            -
            
            
            -Other
            
            
            **48.7**
            
            
            53.1
            
            
            138.9Total
                current assets
            
            
            **495.6**
            
            
            1,055.8
            
            
            634.1Prepaid
                pension costs
            
            
            **195.0**
            
            
            187.6
            
            
            186.1Other
                assets
            
            
            **47.6**
            
            
            46.8
            
            
            53.8Total
                assets
            
            **$**
            **3,299.3**
            
            $
            3,820.3
            
            $
            3,344.8**Capitalization
                and Liabilities**CapitalizationLong-term
                obligationsLong-term
                bonds and notes, net of unamortized discount
            
            **$**
            **447.4**
            
            $
            445.8
            
            $
            495.7Mandatorily
                redeemable preferred stock
            
            
            **3.6**
            
            
            4.1
            
            
            4.0Total
                long-term obligations
            
            
            **451.0**
            
            
            449.9
            
            
            499.7Preferred
                stockNon-redeemable
                preferred stock
            
            
            **1.4**
            
            
            1.4
            
            
            1.4Common
                equityCommon
                stock
            
            
            **76.2**
            
            
            76.2
            
            
            76.2Paid-in
                capital
            
            
            **108.1**
            
            
            108.1
            
            
            108.1Retained
                earnings
            
            
            **471.4**
            
            
            470.7
            
            
            458.9Accumulated
                other comprehensive loss, net
            
            
            **(.2**
            **)**
            
            (.3
            )
            
            (.8
            )Total
                common equity
            
            
            **655.5**
            
            
            654.7
            
            
            642.4Total
                capitalization
            
            
            **1,107.9**
            
            
            1,106.0
            
            
            1,143.5Current
                liabilitiesLong-term
                obligations due within one year
            
            
            **50.5**
            
            
            50.5
            
            
            .5Short-term
                borrowings
            
            
            **151.0**
            
            
            490.0
            
            
            31.0Accounts
                payable
            
            
            **431.7**
            
            
            543.7
            
            
            526.5Accrued
                gas costs
            
            
            **108.9**
            
            
            223.3
            
            
            285.6Deferred
                income taxes
            
            
            **-**
            
            
            24.4
            
            
            27.5Dividends
                payable
            
            
            **12.0**
            
            
            11.0
            
            
            9.0Other
            
            
            **89.5**
            
            
            58.4
            
            
            36.5Total
                current liabilities
            
            
            **843.6**
            
            
            1,401.3
            
            
            916.6Deferred
                credits and other liabilitiesRegulatory
                retirement cost liability
            
            
            **662.8**
            
            
            631.7
            
            
            742.8Deferred
                income taxes
            
            
            **299.1**
            
            
            296.1
            
            
            315.0Asset
                retirement obligation
            
            
            **169.7**
            
            
            164.0
            
            
            -Regulatory
                income tax liability
            
            
            **38.7**
            
            
            41.3
            
            
            42.3Unamortized
                investment tax credits
            
            
            **30.2**
            
            
            31.7
            
            
            32.2Other
            
            
            **147.3**
            
            
            148.2
            
            
            152.4Total
                deferred credits and other liabilities
            
            
            **1,347.8**
            
            
            1,313.0
            
            
            1,284.7Commitments
                and contingenciesTotal
                capitalization and liabilities
            
            **$**
            **3,299.3**
            
            $
            3,820.3
            
            $
            3,344.8The
                accompanying notes are an integral part of these
                statements.




3




Table
          of Contents




**Nicor
      Gas Company**


**Notes
        to the Condensed Consolidated Financial Statements
        (Unaudited)**
 **1.**  **BASIS
          OF PRESENTATION**
 The
        unaudited Condensed Consolidated Financial Statements of Northern Illinois
        Gas
        Company (doing business as Nicor Gas Company (“Nicor Gas”)) have been prepared
        by the company pursuant to the rules and regulations of the United States
        Securities and Exchange Commission (“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 2005 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 in
        storage inventory is carried at cost on a last-in, first-out (“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.
 
 At
        September 30, 2006, the company had an inventory decrement of approximately
        5
        Bcf which it believes will not be restored prior to year-end. The liquidated
        inventory was charged to cost of gas at a LIFO cost of $7.82 per Mcf. If
        the
        company had deemed the decrement to be temporary, it would have charged cost
        of
        gas for the estimated annual replacement cost, currently estimated to be
        about
        $6.32 per Mcf. Applying LIFO cost in valuing the decrement, as opposed to
        the
        estimated annual replacement cost, had the effect of increasing the cost
        of gas
        distributed by $7.5 million during 2006. However, since the cost of gas,
        including inventory costs, is charged to customers without markup, subject
        to
        Illinois Commerce Commission (“ICC”) review, this difference had no impact on
        net income. There was no liquidation of any LIFO layers during 2005.
 
 **Regulatory
        assets and liabilities.** Nicor
        Gas is regulated by the ICC, which establishes the rules and regulations
        governing utility rates and services in Illinois. The company applies accounting
        standards that recognize the economic effects of rate regulation and,
        accordingly, has recorded regulatory assets and liabilities. The company
        had
        regulatory assets and liabilities as follows (in millions):
 
 **September
                  30**
              
              December
                  31
              
              September
                  30**2006**
              
              2005
              
              2005**Regulatory
                  assets**Deferred
                  environmental costs
              
              **$**
              **14.2**
              
              $
              15.1
              
              $
              20.0Unamortized
                  losses on reacquired debt
              
              
              **17.9**
              
              
              18.7
              
              
              19.0Deferred
                  rate case costs
              
              
              **3.1**
              
              
              3.5
              
              
              3.6Other
              
              
              **3.8**
              
              
              .3
              
              
              .4**$**
              **39.0**
              
              $
              37.6
              
              $
              43.0
 
 4
  Table
            of Contents
  
 **September
                  30**
              
              December
                  31
              
              September
                  30**2006**
              
              2005
              
              2005**Regulatory
                  liabilities**Regulatory
                  retirement cost liability - current
              
              **$**
              **9.0**
              
              $
              9.0
              
              $
              12.1Regulatory
                  retirement cost liability - noncurrent
              
              
              **662.8**
              
              
              631.7
              
              
              742.8Accrued
                  gas costs
              
              
              **108.9**
              
              
              223.3
              
              
              285.6Regulatory
                  income tax liability
              
              
              **38.7**
              
              
              41.3
              
              
              42.3Other
              
              
              **.1**
              
              
              1.8
              
              
              7.7**$**
              **819.5**
              
              $
              907.1
              
              $
              1,090.5
 
 All
        regulatory assets noted above are classified in noncurrent other assets.
        The
        current portion of the regulatory retirement cost liability is classified
        in
        current other liabilities. Regulatory liabilities - Other are classified
        in
        noncurrent other liabilities.
 
 **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, 2006 were $12.6
        million and $109.0 million, respectively, and $11.9 million and $109.2 million,
        respectively, for the same periods ending September 30, 2005.
 
 **Reclassifications.** Certain
        reclassifications have been made to conform the prior year’s financial
        statements to the current year’s presentation.
 
 **Income
        and other taxes.** The
        effective income tax rate for the quarter ended September 30, 2006 increased
        to
        35.2 percent from 34.2 percent for the quarter ended September 30, 2005.
        For the
        nine months ended September 30, 2006, the effective income tax rate decreased
        to
        33.2 percent from 33.5 percent for the prior year period. The lower nine
        month
        rate compared to the quarterly rate in 2006 is primarily due to favorable
        tax
        adjustments associated with tax audits (which occur in the normal course
        of
        business) that were recognized in the second quarter.
 
 The
        company accrues tax and interest related to tax uncertainties. Tax uncertainties
        arise due to actual or potential disagreements about the tax treatment of
        specific items between the company and the governmental agency reviewing
        the
        company’s tax returns. At September 30, 2006, December 31, 2005 and September
        30, 2005, the company had accrued approximately $12.7 million, $9.0 million
        and
        $7.9 million, respectively, for such uncertainties.
 
 In
        2003,
        Nicor Gas received an income tax refund of approximately $100 million
        attributable to a tax loss carryback associated with a change in tax accounting
        method (which increased its deferred income tax liability), subject to Internal
        Revenue Service (“IRS”) review and approval as part of normal ongoing audits.
        Through December 31, 2004, the total current tax benefits previously recorded
        under this accounting method approximated $135 million (amounts recorded
        were
        offset by increases to the deferred tax liability with no net effect on reported
        net federal income tax expense). In the third quarter of 2005, the IRS revised
        the regulations pertaining to the aforementioned tax accounting method. The
        new
        regulations require repayment in 2005 and 2006 of amounts previously taken
        as
        current tax deductions. In the second half of 2005 and during the nine months
        ended September 30, 2006, Nicor Gas reclassified income tax expense from
        deferred to current and repaid approximately $67 million and $50 million,
        respectively. The company expects to repay the remaining amounts during the
        fourth quarter of 2006.  The
        anticipated repayment is expected to have no direct impact on earnings and
        no
        material impact on the company’s financial condition.
 
 
 
 
 5
  Table
            of Contents
  
 **3.**  **NEW
        ACCOUNTING PRONOUNCEMENTS**
 
 **Uncertain
        tax positions.** In
        July
        2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation
        No. 48, *Accounting
        for Uncertainty in Income Taxes* .
        This
        Interpretation sets forth a recognition threshold and valuation method to
        recognize and measure an income tax position taken, or expected to be taken,
        in
        a tax return. The evaluation is based on a two-step approach. The first step
        requires an entity to evaluate whether the tax position would “more likely than
        not,” based upon its technical merits, be sustained upon examination by the
        appropriate taxing authority. The second step requires the tax position be
        measured at the largest amount of tax benefit that is greater than 50 percent
        likely of being realized upon ultimate settlement. In addition, previously
        recognized benefits from tax positions that no longer meet the new criteria
        would be derecognized. The application of this Interpretation will be considered
        a change in accounting principle with the cumulative effect of the change
        recorded to the opening balance of retained earnings in the period of adoption.
        This Interpretation will be effective for Nicor Gas on January 1, 2007. The
        company is currently evaluating the Interpretation and the impact it may
        have on
        its results of operations and financial condition, but the impact of initial
        adoption is not expected to be material.
 
 **Fair
        value measurements.** In
        September 2006, the FASB issued Statement of Financial Accounting Standard
        (“SFAS”) No. 157, *Fair
        Value Measurements* .
        This
        Statement defines fair value, establishes a framework for measuring fair
        value
        and expands disclosures about fair value measurements. The 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. This Statement is effective for Nicor Gas no later than January
        1, 2008 and is expected to be adopted prospectively at that time. The company
        is
        currently evaluating the Statement and the impact it may have on the company’s
        results of operations and financial condition.
 
 **Defined
        benefit pension and other postretirement plans.** In
        September 2006, the FASB issued SFAS No. 158, *Employers’*  *Accounting
        for Defined Benefit Pension and Other Postretirement Plans* .
        This
        Statement will require an entity to immediately recognize the funded status
        of a
        defined benefit postretirement plan as an asset or liability in its balance
        sheet, and to recognize changes in that funded status through comprehensive
        income to the extent not recognized in net income pursuant to existing
        accounting rules. As a regulated utility, Nicor Gas expects continued full
        rate
        recovery of the costs of its defined benefit postretirement plans. Therefore,
        the company is evaluating whether changes in the plan’s funded status can be
        deferred as a regulatory asset or liability until recognized in net income,
        instead of being recorded in comprehensive income.
 
 Initial
        and prospective recognition of the funded status of these plans is required
        for
        Nicor Gas beginning at December 31, 2006. The company is evaluating this
        Statement and has not yet determined the impact of adopting its recognition
        provisions. This Statement, had it been adopted at December 31, 2005, would
        have
        reduced the reported pension asset by approximately $50 million and increased
        the liability for health care and other benefits by approximately $85 million.
        Depending on the results of the company’s evaluation discussed above, offsetting
        these amounts would have been a regulatory asset of approximately $135 million
        or a charge to accumulated other comprehensive income of approximately $80
        million ($135 million net of related deferred tax benefits).
 
 This
        Statement will also require Nicor Gas to change its plan measurement date
        to
        December 31. Such provision is effective for Nicor Gas no later than December
        31, 2008 and will be adopted prospectively at that time. The company has
        not yet
        determined the impact of adopting this provision.
 
 
 
 
 6
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 **4.**  **ASSET
        RETIREMENT OBLIGATIONS**
 
 Nicor
        Gas
        has asset retirement obligations (“AROs”) associated with services, mains and
        other components of the distribution system and buildings. Nicor Gas has
        not
        recognized an ARO associated with gathering lines and storage wells because
        there is insufficient company or industry retirement history to reasonably
        estimate the fair value of the obligation.
 
 The
        following table presents a reconciliation of the beginning and ending ARO
        for
        the nine months ended September 30, 2006 (in millions):
 
 Beginning
                  of period
              
              **$**
              **164.4**Liabilities
                  incurred during the period
              
              
              **1.7**Liabilities
                  settled during the period
              
              
              **(2.1**
              **)**Accretion
              
              
              **7.1**Revision
                  in estimated cash flows
              
              
              **.5**End
                  of period
              
              **$**
              **171.6**
 
 Substantially
        all of the ARO is classified as a noncurrent liability.
 
 **5.**  **SHORT-TERM
        AND LONG-TERM DEBT**
 
 In
        October 2006, Nicor Gas established a $400 million, 210-day seasonal revolver,
        which expires in May 2007, to replace the $400 million, 210-day seasonal
        revolver, which expired in April 2006. In September 2005, Nicor Gas and its
        parent company, Nicor Inc. (“Nicor”), 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 $151.0 million, $490.0 million and $31.0 million of
        commercial paper borrowings outstanding at September 30, 2006, December 31,
        2005
        and September 30, 2005, respectively.
 
 In
        October 2006, Nicor Gas entered into an agreement for the issuance of $50
        million First Mortgage Bonds at 5.85 percent, due in 2036. The issuance is
        expected to occur, subject to the satisfaction of the conditions in the
        underlying agreements, on the maturity date of the $50 million 5.55 percent
        First Mortgage Bond series due in December 2006.
 
 The
        company believes it is in compliance with all debt covenants.
 
 **6.**  **ACCRUED
        UNBILLED REVENUES**
 
 Receivables
        include accrued unbilled revenues of $52.4 million, $300.4 million and $52.5
        million at September 30, 2006, December 31, 2005 and September 30, 2005,
        respectively. Nicor Gas accrues revenues for estimated deliveries to customers
        from the date of their last bill until the balance sheet date.
 
 **7.**  **FAIR
        VALUE OF FINANCIAL INSTRUMENTS**
 
 The
        recorded amount of short-term investments and short-term borrowings approximates
        fair value because of the short maturity of the instruments. Long-term debt
        outstanding, including current maturities, is recorded at the principal balance
        outstanding, net of unamortized discount. The principal balance of Nicor
        Gas’
First Mortgage Bonds outstanding at September 30, 2006, December 31, 2005
        and
        September 30, 2005 was $500 million. Based on quoted market interest rates,
        the
        fair value of the company’s First Mortgage Bonds outstanding, including current
        maturities, was approximately $515 million, $525 million and $531 million
        at
        September 30, 2006, December 31, 2005 and September 30, 2005,
        respectively.
  7
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 Derivative
        financial instruments are recorded at fair value as determined primarily
        from
        actively quoted prices. The majority of these financial instruments relate
        to
        hedging of natural gas purchases, and their settlement is passed directly
        through to customers without markup, subject to ICC review. The gross asset
        and
        liability fair values of these instruments are reflected on the Condensed
        Consolidated Balance Sheets as follows (in millions):
 
 **September
                  30**
              
              December
                  31
              
              September
                  30**2006**
              
              2005
              
              2005Current
                  other assets
              
              **$**
              **3.7**
              
              $
              25.7
              
              $
              96.4Noncurrent
                  other assets
              
              
              **.1**
              
              
              1.0
              
              
              2.1**$**
              **3.8**
              
              $
              26.7
              
              $
              98.5Current
                  other liabilities
              
              **$**
              **47.1**
              
              $
              .8
              
              $
              -Noncurrent
                  other liabilities
              
              
              **3.6**
              
              
              .1
              
              
              .1**$**
              **50.7**
              
              $
              .9
              
              $
              .1
 
 Nicor
        Gas
        maintains a margin account related to financial derivative transactions.
        At
        September 30, 2006, December 31, 2005 and September 30, 2005, the balance
        of
        this account was $30.2 million, $33.7 million and zero, respectively, and
        was
        reflected on the Condensed Consolidated Balance Sheets as
        Receivables.
 
 **8.**  **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
        unionized 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 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.
 
 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 operating and maintenance expense. Net periodic
        benefit
        cost (credit) included the following components (in millions):
 
 
 
  
 
 
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 Pension
                  benefits
              
              Health
                  care and
                other
                  benefits**2006**
              
              2005
              
              **2006**
              
              2005**Three
                  months ended September 30**Service
                  cost
              
              **$**
              **2.3**
              
              $
              2.3
              
              **$**
              **.6**
              
              $
              .7Interest
                  cost
              
              
              **3.8**
              
              
              3.9
              
              
              **2.5**
              
              
              2.6Expected
                  return on plan assets
              
              
              **(8.8**
              **)**
              
              (8.3
              )
              
              **(.1**
              **)**
              
              (.2
              )Recognized
                  net actuarial loss
              
              
              **.1**
              
              
              .4
              
              
              **1.4**
              
              
              1.1Amortization
                  of prior service cost
              
              
              **.1**
              
              
              .2
              
              
              **(.1**
              **)**
              
              -Net
                  periodic benefit cost (credit)
              
              **$**
              **(2.5**
              **)**
              $
              (1.5
              )
              **$**
              **4.3**
              
              $
              4.2**Nine
                  months ended September 30**Service
                  cost
              
              **$**
              **7.0**
              
              $
              7.0
              
              **$**
              **1.8**
              
              $
              2.0Interest
                  cost
              
              
              **11.2**
              
              
              11.7
              
              
              **7.7**
              
              
              7.7Expected
                  return on plan assets
              
              
              **(26.2**
              **)**
              
              (24.9
              )
              
              **(.2**
              **)**
              
              (.7
              )Recognized
                  net actuarial loss
              
              
              **.2**
              
              
              1.1
              
              
              **3.8**
              
              
              3.8Amortization
                  of prior service cost
              
              
              **.4**
              
              
              .5
              
              
              **(.1**
              **)**
              
              (.1
              )Net
                  periodic benefit cost (credit)
              
              **$**
              **(7.4**
              **)**
              $
              (4.6
              )
              **$**
              **13.0**
              
              $
              12.7
 
 The
        company reflected its best estimate of the potential subsidy it may receive
        under the Medicare Prescription Drug, Improvement and Modernization Act of
        2003
        in its October 1, 2005 and 2004 measurement of the postretirement health
        care
        obligation and of net periodic postretirement health care costs. The estimated
        subsidy reduced such costs by $1.3 million and $4.0 million for the three
        and
        nine months ended September 30, 2006, respectively, and $0.6 million and
        $1.8
        million, respectively, for the corresponding prior-year periods.
 
 **9.**  **COMPREHENSIVE
        INCOME**
 
 Total
        comprehensive income, as defined by SFAS No. 130, *Reporting
        Comprehensive Income* ,
        is
        equal to net income plus other comprehensive income and is as follows (in
        millions):
 
 Three
                  months ended
              
              Nine
                  months endedSeptember
                  30
              
              September
                  30**2006**
              
              2005
              
              **2006**
              
              2005Net
                  income (loss)
              
              **$**
              **(1.6**
              **)**
              $
              (5.4
              )
              **$**
              **36.8**
              
              $
              30.6Other
                  comprehensive income, after tax
              
              
              **-**
              
              
              -
              
              
              **-**
              
              
              .7Total
                  comprehensive income (loss)
              
              **$**
              **(1.6**
              **)**
              $
              (5.4
              )
              **$**
              **36.8**
              
              $
              31.3
 
 Net
        other
        comprehensive income for the nine months ended September 30, 2005 consists
        primarily of a reduction to the minimum pension liability resulting from
        a
        settlement in an unfunded supplemental retirement plan in the second quarter
        of
        2005.
 
 **10.**  **RELATED
        PARTY TRANSACTIONS**
 
 In
        the
        ordinary course of business, under the terms of an agreement approved by
        the
        ICC, Nicor Gas enters into transactions with Nicor and its other wholly owned
        subsidiaries for the use of facilities and services. The charges for these
        transactions are cost-based, except where the charging party has a prevailing
        price for which the facility or service is provided to the general public.
        In
        addition, Nicor
 
 
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  charges
        Nicor Gas and its other wholly owned subsidiaries for the cost of corporate
        overheads. For the three and nine months ended September 30, 2006, Nicor
        Gas had
        net charges to (from) affiliates of $(0.4) million and $7.0 million,
        respectively. For the three and nine months ended September 30, 2005, Nicor
        Gas
        had net charges to (from) affiliates of $(0.6) million and $5.4 million,
        respectively.
 
 Nicor
        Gas
        participates in a cash management system with other subsidiaries of Nicor.
        By
        virtue of making deposits or advances to Nicor, Nicor Gas is exposed to credit
        risk to the extent it is unable to secure the return of such deposits for
        any
        reason. Such deposits are due on demand. There are ICC regulations addressing
        the amount and circumstances in which Nicor Gas can deposit with the cash
        management pool or advance to affiliates. In addition, Nicor Gas may not
        extend
        cash advances to an affiliate if Nicor Gas has any outstanding short-term
        borrowings. Nicor Gas’ practice also provides that the balance of cash deposits
        or advances from Nicor Gas to an affiliate at any time shall not exceed the
        unused balance of funds actually available to that affiliate under its existing
        bank credit agreements or its commercial paper facilities with unaffiliated
        third parties. Nicor Gas’ positive cash deposits, if any, may be applied by
        Nicor to offset negative balances of other Nicor subsidiaries and vice
        versa.
 
 Nicor
        Gas
        had no deposits in the Nicor cash management pool at September 30, 2006,
        December 31, 2005 and September 30, 2005, respectively, due primarily to
        the
        seasonal cash requirements of the business. Nicor Gas records interest income
        from deposits in the Nicor cash management pool at a rate of interest equal
        to
        the higher of Nicor’s commercial paper rate or a market rate of return on a
        short-term investment. For the three and nine months ended September 30,
        2006,
        Nicor Gas recorded interest income of $0.8 million and $2.3 million,
        respectively, from these deposits. For the three and nine months ended September
        30, 2005, interest income was $0.7 million and $1.8 million,
        respectively.
 
 Nicor
        Solutions, a wholly owned business of Nicor, offers utility-bill management
        products to customers of Nicor Gas. Under these products, Nicor Solutions
        pays
        Nicor Gas for the utility bills issued to the utility-bill management customers.
        For the three and nine months ended September 30, 2006, Nicor Gas recorded
        revenues of $5.5 million and $58.9 million, respectively, associated with
        the
        payments Nicor Solutions makes to Nicor Gas on behalf of its customers. For
        the
        three and nine months ended September 30, 2005, such revenues were $5.6 million
        and $50.1 million, respectively.
 
 Nicor
        Gas
        enters into routine transactions with Nicor Enerchange, a wholly owned wholesale
        natural gas marketing business of Nicor, for the purchase and sale of natural
        gas, transportation and storage services. Such transactions are governed
        by
        terms of an ICC order. For the three and nine months ended September 30,
        2006,
        net charges from Nicor Enerchange were $4.5 million and $28.8 million,
        respectively. For the three and nine months ended September 30, 2005, net
        charges from Nicor Enerchange were $0.5 million and $9.0 million,
        respectively.
 
 Horizon
        Pipeline, a 50-percent-owned joint venture of Nicor, charged Nicor Gas $2.6
        million and $7.8 million for the three and nine months ended September 30,
        2006,
        respectively, for natural gas transportation under rates that have been accepted
        by the Federal Energy Regulatory Commission. For the three and nine months
        ended
        September 30, 2005, Horizon Pipeline charged Nicor Gas $2.6 million and $7.8
        million, respectively.
 
 EN
        Engineering, a 50-percent-owned joint venture of Nicor, charged Nicor Gas
        $1.3
        million and $3.1 million for the three and nine months ended September 30,
        2006,
        respectively, for engineering and corrosion services. For the three and nine
        months ended September 30, 2005, Nicor Gas was charged $1.1 million and $3.2
        million, respectively, for these services.
 
 
 
 10
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 Key
        executives and managerial employees of Nicor Gas participate in Nicor’s
        stock-based compensation plans. For the three and nine-month periods ended
        September 30, 2006, Nicor Gas recognized $0.7 million and $2.1 million,
        respectively, of compensation expense for stock-based compensation in accordance
        with SFAS No. 123 (revised 2004), *Share-Based
        Payment* .
 
 In
        addition, certain related parties may acquire regulated utility services
        at
        rates approved by the ICC.
 
 **11.** **RATE
        PROCEEDING**
 
 Nicor
        Gas
        filed a request with the ICC for an overall increase in base rates on November
        4, 2004. In late 2005, Nicor Gas received approval from the ICC for a $54.2
        million base rate increase which reflected an allowed rate of return on
        original-cost rate base of 8.85 percent, including a 10.51 percent cost of
        common equity. The order also included the authorization to pass all Chicago
        Hub
        revenues directly through to customers as a credit to Nicor Gas’ Purchased Gas
        Adjustment (“PGA”) rider and the shifting of certain storage-related costs from
        the PGA rider to base rates. In addition, rates were established using a
        10-year
        average for weather as opposed to the previous use of a 30-year average.
        These
        rates were implemented in the fourth quarter of 2005.
 
 In
        October 2005, Nicor Gas and six other parties filed applications for rehearing
        of the final order of the rate case. The ICC granted rehearing on seven issues,
        only two of which relate to the amount of the approved annual net revenue
        increase, and denied rehearing on all other issues raised in the applications.
        In March 2006, the ICC issued its decision on rehearing in which it adjusted
        the
        amount of the annual net rate increase to $49.7 million from the $54.2 million
        that had been approved in the earlier order. Rate changes resulting from
        the
        rehearing order are prospective and went into effect on April 11, 2006. Parties,
        including Nicor Gas, that appealed the ICC’s rate case decision to the state
        appellate courts have since withdrawn their appeals. As a result, the ICC
        rate
        order is no longer subject to judicial review.
 
 As
        a
        result of the rate order, which became effective in the fourth quarter of
        2005,
        certain storage-related costs are now recorded in operating and maintenance
        expense. For the three and nine months ended September 30, 2006, storage-related
        gas costs in operating and maintenance expense totaled $1.0 million and $15.4
        million, respectively. Such costs totaled zero and $11.1 million, respectively,
        for the corresponding prior-year periods and since they were incurred prior
        to
        the effective date of the rate order were recorded as cost of gas.
 
 **12.**  **GUARANTEES**
 
 In
        certain instances, Nicor Gas 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 cleanup,
        as
        discussed in Note 13 - Contingencies - Manufactured Gas Plant Sites, Nicor
        Gas
        believes that the likelihood of payment under these indemnifications is either
        remote, or the fair value of the indemnification is immaterial and no liability
        has been recorded for these indemnifications.
 
 Nicor
        Gas
        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. While the company
        does not expect to incur significant costs under these indemnifications,
        it is
        not possible to estimate the maximum potential payments.
 
 
 11
 Table
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  **13.**  **CONTINGENCIES**
 
 The
        following contingencies of Nicor Gas are in various stages of investigation
        or
        disposition. Although in some cases the company is unable to estimate the
        amount
        of loss reasonably possible in addition to any amounts already recognized,
        it is
        possible that the resolution of these contingencies, either individually
        or in
        aggregate, will require the company to take charges against, or will result
        in
        reductions in, future earnings. It is the opinion of management that the
        resolution of these contingencies, either individually or in aggregate, could
        be
        material to earnings in a particular period but is not expected to have a
        material adverse impact on Nicor Gas’ liquidity or financial
        condition.
 
 **Performance-Based
        Rate (“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. Parties
        who were plaintiffs in a dismissed class action proceeding against the company
        could potentially intervene in these proceedings. 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. In addition, Nicor Gas estimates that there is
        $26.9
        million due to the company from the 2002 PBR plan year, which has not been
        recognized in the financial statements due to uncertainties surrounding the
        PBR
        plan. The net of these items and interest income on certain components results
        in a $1.0 million reimbursement the company is seeking as of September 30,
        2006,
        pending resolution of the proceedings discussed below. By the end of 2003,
        the
        company completed steps to correct the weaknesses and deficiencies identified
        in
        the detailed study of the adequacy of internal controls.
 
 Pursuant
        to the agreement of all parties, including the company, the ICC re-opened
        the
        1999 and 2000 purchased gas adjustment filings for review of certain
        transactions related to the PBR plan and consolidated the reviews of the
        1999-2002 purchased gas adjustment filings with the PBR plan review.
 
 
 
 
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  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. Nicor Gas filed
        rebuttal testimony in January 2004, which is consistent with the findings
        of the
        special committee Report. Nicor Gas seeks a reimbursement of approximately
        $1
        million as referenced above. The parties to the ICC Proceedings have agreed
        to a
        stay of the evidentiary hearings on this matter in order 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.
 
 During
        the course of the United States Securities and Exchange Commission (“SEC”)
        investigation discussed below, the company became aware of additional
        information relating to the activities of individuals affecting the PBR plan
        for
        the period from 1999 through 2002, including information consisting of third
        party documents and recordings of telephone conversations from EKT. Review
        of
        additional information completed in 2004 resulted in the $1.8 million adjustment
        to the previously recorded liability referenced above.
 
 Although
        the Report of the special committee’s counsel did not find that there was
        criminal activity or fraud, a review of this additional information (which
        was
        not available to the independent counsel who prepared the Report) and
        re-interviews of certain Nicor Gas personnel in 2004 indicated that certain
        former Nicor Gas personnel may have engaged in potentially fraudulent conduct
        regarding the PBR plan in violation of company policy, and in possible violation
        of SEC rules and applicable law. Further, certain former Nicor Gas personnel
        also may have attempted to conceal their conduct in connection with an ICC
        review of the PBR plan. The company continues to cooperate with the SEC,
        the
        U.S. Attorney’s office and the ICC on this matter. The company has reviewed all
        third party information it has obtained and will continue to review any
        additional third party information the company may obtain. The company
        terminated four employees in connection with this matter in 2004.
 
 Nicor
        Gas
        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,
        2006.
 
 
 
 
 
 
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            of Contents
  **SEC
        and U.S. Attorney Inquiries.** In 2002,
        the staff of the SEC Division of Enforcement (“SEC Staff”) informed the company
        that the SEC is conducting a formal inquiry regarding the PBR plan. A
        representative of the Office of the United States Attorney for the Northern
        District of Illinois (the “U.S. Attorney”) has notified the company that that
        office is conducting an inquiry on the same matter that the SEC is
        investigating, and a grand jury is also reviewing this matter. In April 2004,
        Nicor was advised by the SEC Staff that it intended to recommend to the SEC
        that
        it bring a civil injunctive action against Nicor, alleging that Nicor violated
        Sections 17(a) of the Securities Act of 1933 and Sections 10(b) and 13(a)
        of the
        Securities Exchange Act of 1934 and Rules 10b-5, 12b-20, 13a-1 and 13a-13
        thereunder. On July 7, 2006, Nicor announced that it reached a tentative
        agreement with the SEC Staff in settlement of an anticipated civil action
        to
        which Nicor and the SEC will be parties. Under the terms of the tentative
        settlement, Nicor will be subject to disgorgement of one dollar, a monetary
        fine
        of $10 million and an injunction. Nicor will neither admit nor deny any
        wrongdoing. In July 2006, Nicor deposited the $10 million in escrow pending
        final approval of the tentative settlement by the SEC commissioners and entry
        of
        a final judgment by a federal court. The SEC Staff will submit the tentative
        settlement to the SEC commissioners for approval. The SEC commissioners have
        the
        authority to approve, modify or reject the tentative settlement. Nicor recorded
        a $10 million charge to its second quarter earnings in connection with this
        matter. As the tentative settlement is between Nicor and the SEC Staff, Nicor
        Gas has not recorded a liability associated with the outcome of the SEC matter.
        The company is unable to predict the outcome of the separate inquiry by the
        U.S.
        Attorney or the company’s potential exposure related thereto and has not
        recorded a liability associated with the outcome of that matter.
 
 **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.
 
 Nicor
        Gas
        is a defendant in several private lawsuits, all in the Circuit Court of Cook
        County, Illinois, seeking a variety of unquantified damages (including bodily
        injury, property and punitive damages) allegedly caused by mercury spillage
        resulting from the removal of mercury-containing regulators. Under the terms
        of
        a class action settlement agreement, Nicor Gas will continue, until 2007,
        to
        provide medical screening to persons exposed to mercury from its equipment,
        and
        will use reasonable efforts to remove any remaining inside residential mercury
        regulators by March of 2006. Nicor Gas believes it is in compliance with
        its
        obligations under the settlement agreement. The class action settlement
        permitted class members to “opt out” of the settlement and pursue their claims
        individually. Nicor Gas is currently defending claims brought by 26
        households.
 
 As
        of
        September 30, 2006, Nicor Gas had remaining an estimated liability of $15.3
        million, representing management’s best estimate of future costs, including
        potential liabilities relating to remaining lawsuits, based on an evaluation
        of
        currently available information. Actual costs may vary from this estimate.
        The
        company will continue to reassess its estimated obligation and will record
        any
        necessary adjustment, which could be material to operating results in the
        period
        recorded.
 
 Nicor
        Gas
        continues to pursue recovery from insurers and independent contractors that
        had
        performed work for the company. When received, these recoveries are recorded
        as
        a reduction to operating expense. Nicor Gas received approximately $3.8 million,
        net of legal fees, from an independent contractor in the first quarter of
        2006.
        Amounts recovered during 2004 and 2005 were immaterial. On October 25, 2004,
        the
        Circuit Court of Cook County, Illinois entered judgment in favor of Nicor
        and
        Nicor Gas and against various insurers in the amount of $10.2 million with
        respect to one of Nicor’s and Nicor Gas’ mercury-related insurance claims. The
        insurers filed an appeal of the judgment. On November 29, 2005, the First
        District Appellate Court reversed the Circuit Court’s judgment in favor of Nicor
        and Nicor Gas and remanded the case to the Circuit Court for proceedings
        consistent with the Appellate Court’s decision. The Illinois Supreme Court has
        granted Nicor and Nicor Gas leave to appeal the decision of the Appellate
        Court.
 
 
 14
 Table
            of Contents
  The
        final
        disposition of these mercury-related matters is not expected to have a material
        adverse impact on the company’s 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.
        The ultimate outcome of this arbitration is not presently determinable.
        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
        determine the extent additional remediation is necessary and provide a basis
        for
        estimating additional future costs. As of September 30, 2006, the company
        had
        recorded a liability in connection with these matters of $14.1 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
        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 cleanup of a former manufactured gas plant site
        in
        Oak Park, Illinois was inadequate. Since then, additional lawsuits have been
        filed related to this same former manufactured gas plant site. These lawsuits
        seek, in part, unspecified damages for property damage, nuisance, and various
        personal injuries that allegedly resulted from exposure to contaminants
        allegedly emanating from the site, and punitive damages. An agreement in
        principle to settle the purported class action lawsuit has been reached and,
        as
        of September 30, 2006, the company has recorded a $2.25 million liability
        in
        connection with this matter. In accordance with ICC authorization, the company
        expects to recover costs of such settlement from its customers, subject to
        an
        annual prudence review. Management cannot predict the outcome of certain
        other
        pending lawsuits relating to the Oak Park site or the company’s potential
        exposure thereto and has not recorded a liability associated with those other
        pending matters.
 
 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 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.
 
 
 
 15
 Table
            of Contents
  **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, rates, 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.
 
 
 
  
 
 
 
 
 
 
 
 
 
 
 16
  Table
            of Contents
  **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 Northern Illinois Gas Company, doing
        business as Nicor Gas Company (“Nicor Gas”), 2005 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.
 
 **RESULTS
        OF OPERATIONS**
 
 The
        following table provides a comparison of Nicor Gas’ results as reported for the
        three and nine-month periods ended September 30, 2006 and 2005 (in
        millions):
  Three
                  months ended
              
              Nine
                  months endedSeptember
                  30
              
              September
                  30**2006**
              
              2005
              
              **2006**
              
              2005Operating
                  income
              
              **$**
              **7.2**
              
              $
              3.8
              
              **$**
              **63.2**
              
              $
              58.5Net
                  income (loss)
              
              
              **(1.6**
              **)**
              
              (5.4
              )
              
              **36.8**
              
              
              30.6
 
 Net
        income (loss) for the three and nine months ended September 30, 2006, compared
        with the year-earlier periods improved by $3.8 million and $6.2 million,
        respectively, due primarily to the positive effects of higher margin ($11.4
        million and $26.7 million pretax increases, respectively), partially offset
        by
        higher operating and maintenance expenses ($5.5 million and $21.6 million
        pretax
        increases, respectively) and higher depreciation expense ($1.5 million and
        $4.4
        million pretax increases, respectively). The year-to-date 2006 results were
        also
        favorably impacted by a first quarter pretax mercury-related recovery of
        $3.8
        million.
 
 **Rate
        proceeding** .
        Nicor
        Gas filed a request with the Illinois Commerce Commission (“ICC”) for an overall
        increase in base rates on November 4, 2004. In late 2005, Nicor Gas received
        approval from the ICC for a $54.2 million base rate increase which reflected
        an
        allowed rate of return on original-cost rate base of 8.85 percent, including
        a
        10.51 percent cost of common equity. The order also included the authorization
        to pass all Chicago Hub revenues directly through to customers as a credit
        to
        Nicor Gas’ Purchased Gas Adjustment (“PGA”) rider and the shifting of certain
        storage-related costs from the PGA rider to base rates. In addition, rates
        were
        established using a 10-year average for weather as opposed to the previous
        use
        of a 30-year average. These rates were implemented in the fourth quarter
        of
        2005. Because the order shifts certain items between base rates and Nicor
        Gas’
PGA rider, the company estimated that, under normal weather conditions and
        demand as reflected in the rate case, the annual net revenue increase resulting
        from implementing the rate order would have been about $34.7 million under
        the
        tariffs that were placed into effect.
 
 In
        October 2005, Nicor Gas and six other parties filed applications for rehearing
        of the final order of the rate case.  The ICC granted rehearing on seven
        issues, only two of which relate to the amount of the approved annual net
        revenue increase, and denied rehearing on all other issues raised in the
        applications. In March 2006, the ICC issued its decision on rehearing in
        which
        it adjusted the amount of the annual net rate increase to $49.7 million from
        the
        $54.2 million that had been approved in the earlier order. The company estimates
        that because the revised order similarly shifts certain items between base
        rates
        and
 
 
 
 
 
 
 17
  Table
            of Contents
  
 Nicor
        Gas’ PGA rider, under normal weather conditions and demand as reflected in the
        rate case, the annual net revenue increase will decrease to $30.2 million
        from
        the estimated $34.7 million under the previous order. Rate changes resulting
        from the rehearing order are prospective and went into effect on April 11,
        2006.
        Parties, including Nicor Gas, that appealed the ICC’s rate case decision to the
        state appellate courts have since withdrawn their appeals. As a result, the
        ICC
        rate order is no longer subject to judicial review.
 
 As
        a
        result of the rate order which became effective in the fourth quarter of
        2005,
        certain storage-related costs are now recorded in operating and maintenance
        expense. For the three and nine months ended September 30, 2006, storage-related
        gas costs in operating and maintenance expense totaled $1.0 million and $15.4
        million, respectively. Such costs totaled zero and $11.1 million, respectively,
        for the corresponding prior-year periods and since they were incurred prior
        to
        the effective date of the rate order were recorded as cost of gas.
 
 **Operating
        revenues.** Operating
        revenues are impacted by changes in natural gas costs, which are passed directly
        through to customers without markup, subject to ICC review. For the third
        quarter of 2006 compared with a year ago, revenues decreased $14.8 million
        due
        to lower natural gas costs (approximately $50 million decrease), partially
        offset by the impact of colder weather than in 2005 (approximately $13 million
        increase) and the base rate increase (approximately $11 million). For the
        2006
        year-to-date period compared with a year ago, revenues increased $83.0 million
        due to higher natural gas costs (approximately $175 million increase) and
        the
        impact of the base rate increase (approximately $36 million), partially offset
        by the negative impact of warmer weather than the corresponding period in
        2005
        (approximately $126 million decrease) and lower demand unrelated to weather
        (approximately $21 million decrease).
 
 **Margin.** Nicor
        Gas
        utilizes a measure it refers to as “margin” to evaluate the operating income
        impact of revenues. Revenues include natural gas costs, which are passed
        directly through to customers without markup, subject to ICC review, and
        revenue
        taxes, for which Nicor Gas earns a small administrative fee. These items
        often
        cause significant fluctuations in revenues, and yet they have virtually no
        direct impact on operating income.
 
 A
        reconciliation of revenues and margin follows (in millions):
 
 Three
                  months ended
              
              Nine
                  months endedSeptember
                  30
              
              September
                  30**2006**
              
              2005
              
              **2006**
              
              2005Revenues
              
              **$**
              **226.7**
              
              $
              241.5
              
              **$**
              **1,775.6**
              
              $
              1,692.6Cost
                  of gas
              
              
              **(108.0**
              **)**
              
              (134.9
              )
              
              **(1,258.8**
              **)**
              
              (1,202.3
              )Revenue
                  tax expense
              
              
              **(12.6**
              **)**
              
              (11.9
              )
              
              **(109.0**
              **)**
              
              (109.2
              )Margin
              
              **$**
              **106.1**
              
              $
              94.7
              
              **$**
              **407.8**
              
              $
              381.1
 
 Margin
        increased $11.4 million in the third quarter of 2006 compared with the
        corresponding prior-year period due primarily to the impact of the base rate
        increase (approximately $11 million assuming normal weather). Year-to-date
        2006
        margin increased $26.7 million compared with the corresponding prior-year
        period
        due primarily to the impact of the base rate increase (approximately $36
        million), partially offset by the negative impact of warmer weather than
        in 2005
        (approximately $8 million decrease) and lower demand unrelated to weather
        (approximately $3 million decrease).
 
 
 
 
 18
  Table
            of Contents
  
 **Operating
        and maintenance expense.** Operating and maintenance expense increased **** $5.5
        million to $56.4 million in the third quarter of 2006 from $50.9 million
        in the
        prior-year period due to higher company use gas ($4.1 million increase) and
        higher bad debt expense ($1.3 million increase). Year-to-date operating and
        maintenance expense increased $21.6 million to $199.2 million from $177.6
        million in the prior-year period due primarily to higher storage-related
        gas
        costs ($15.4 million increase), company use gas ($11.0 million increase)
        and bad
        debt expense ($3.3 million increase), partially offset by lower payroll and
        benefit-related costs ($3.6 million decrease) and claims arising from normal
        operations ($4.2 million decrease).
 
 Transfer,
        in the 2005 rate order, of recovery of certain storage-related gas costs
        from
        the PGA rider to base rates results in those costs being charged to operating
        and maintenance expense. Prior to the effective date of the rate order, these
        storage-related gas costs, which were zero and $11.1 million in the three
        and
        nine-month periods ended September 30, 2005, respectively, were charged to
        cost
        of gas and passed through to customers as part of the PGA rider.
 
 **Mercury-related
        costs (recoveries)** , **net.** Mercury-related
        costs (recoveries), net reflect estimated costs, credits and recoveries
        associated with the company’s mercury inspection and repair program. During the
        first quarter of 2006, a mercury-related recovery of $3.8 million was realized.
        This net recovery resulted from a settlement reached with an independent
        contractor of Nicor Gas. Additional information about the company’s mercury
        inspection and repair program is presented in Item 1 - Notes to the Condensed
        Consolidated Financial Statements - Note 13 - Contingencies -
        Mercury.
 
 **Property
        sale gains.** Property
        sale gains and losses vary from year-to-year depending upon property sales
        activity. Nicor Gas realized a $0.6 million and $3.2 million pretax gain
        on the
        sale of property for the three and nine months ended September 30, 2006,
        respectively. The company continues to assess its ownership of certain real
        estate holdings.
 
 **Interest
        income.** Interest
        income increased $0.6 million and $2.1 million for the three and nine-month
        periods ended September 30, 2006, respectively, over the corresponding
        prior-year periods due primarily to higher investment balances and higher
        average rates.
 
 **Income
        taxes.** The
        effective income tax rate for the quarter ended September 30, 2006 increased
        to
        35.2 percent from 34.2 percent for the quarter ended September 30, 2005.
        For the
        nine months ended September 30, 2006, the effective income tax rate decreased
        to
        33.2 percent from 33.5 percent for the prior year period. The lower nine-month
        rate compared to the quarterly rate in 2006 is primarily due to favorable
        tax
        adjustments associated with tax audits (which occur in the normal course
        of
        business) that were recognized in the second quarter.
 
 **Interest
        expense.** Interest
        expense of $10.3 million in the third quarter of 2006 is comparable to the
        corresponding 2005 period as higher average borrowing levels ($0.5 million
        increase) were offset by lower average interest rates ($0.5 million decrease).
        Interest  expense
        of $31.5 million for the nine-month period ended September 30, 2006 increased
        $1.3 million over the corresponding prior-year period due primarily to higher
        average borrowing levels ($2.2 million increase), partially offset by lower
        average interest rates ($0.6 million decrease).
 
 
 
 
 
 
 19


Table
          of Contents


**Nicor
                Gas Company****Operating
                Statistics****Three
                months ended**
            
            **Nine
                months ended****September
                30**
            
            **September
                30****2006**
            
            2005
            
            **2006**
            
            2005**Operating
                revenues**(millions)SalesResidential
            
            **$**
            **136.8**
            
            $
            152.4
            
            **$**
            **1,207.5**
            
            $
            1,140.7Commercial
            
            
            **29.8**
            
            
            36.0
            
            
            **275.2**
            
            
            255.0Industrial
            
            
            **2.7**
            
            
            4.3
            
            
            **31.9**
            
            
            34.9**169.3**
            
            
            192.7
            
            
            **1,514.6**
            
            
            1,430.6TransportationResidential
            
            
            **6.1**
            
            
            4.8
            
            
            **21.9**
            
            
            19.1Commercial
            
            
            **14.7**
            
            
            11.5
            
            
            **57.7**
            
            
            51.0Industrial
            
            
            **10.7**
            
            
            10.4
            
            
            **29.1**
            
            
            29.4Other
            
            
            **1.1**
            
            
            1.0
            
            
            **2.0**
            
            
            8.6**32.6**
            
            
            27.7
            
            
            **110.7**
            
            
            108.1Other
                revenuesRevenue
                taxes
            
            
            **12.9**
            
            
            12.8
            
            
            **111.5**
            
            
            112.4Environmental
                cost recovery
            
            
            **.8**
            
            
            1.4
            
            
            **7.2**
            
            
            15.9Chicago
                Hub
            
            
            **8.1**
            
            
            2.4
            
            
            **13.9**
            
            
            7.5Other
            
            
            **3.0**
            
            
            4.5
            
            
            **17.7**
            
            
            18.1**24.8**
            
            
            21.1
            
            
            **150.3**
            
            
            153.9**$**
            **226.7**
            
            $
            241.5
            
            **$**
            **1,775.6**
            
            $
            1,692.6**Deliveries**(Bcf)SalesResidential
            
            
            **13.9**
            
            
            12.0
            
            
            **121.6**
            
            
            131.2Commercial
            
            
            **3.2**
            
            
            3.1
            
            
            **27.9**
            
            
            29.5Industrial
            
            
            **.4**
            
            
            .4
            
            
            **3.4**
            
            
            4.1**17.5**
            
            
            15.5
            
            
            **152.9**
            
            
            164.8TransportationResidential
            
            
            **1.2**
            
            
            1.1
            
            
            **10.7**
            
            
            12.7Commercial
            
            
            **11.2**
            
            
            8.8
            
            
            **59.5**
            
            
            60.9Industrial
            
            
            **23.1**
            
            
            25.1
            
            
            **75.2**
            
            
            84.7**35.5**
            
            
            35.0
            
            
            **145.4**
            
            
            158.3**53.0**
            
            
            50.5
            
            
            **298.3**
            
            
            323.1**Customers
                at end of period**(thousands)SalesResidential
            
            
            **1,784.5**
            
            
            1,771.2Commercial
            
            
            **121.6**
            
            
            117.9Industrial
            
            
            **7.1**
            
            
            7.3**1,913.2**
            
            
            1,896.4TransportationResidential
            
            
            **161.0**
            
            
            160.0Commercial
            
            
            **56.6**
            
            
            57.6Industrial
            
            
            **5.5**
            
            
            5.9**223.1**
            
            
            223.5**2,136.3**
            
            
            2,119.9**Other
                statistics**Degree
                days
            
            
            **84**
            
            
            26
            
            
            **3,301**
            
            
            3,572Colder
                (warmer) than normal*
            
            
            20
            %
            
            (63
            )%
            
            **(12**
            **)%**
            
            (5
            )%Average
                gas cost per Mcf sold
            
            **$**
            **6.05**
            
            $
            8.53
            
            **$**
            **8.18**
            
            $
            7.22*
                Normal weather for Nicor Gas' service territory, for purposes of
                this
                report, is considered to be 5,830degree
                days per year.




20




Table
          of Contents


**FINANCIAL
      CONDITION AND LIQUIDITY**





**Operating
      activities.** This
      business is highly seasonal and operating cash flow may fluctuate significantly
      during the year and from year-to-year due to factors such as weather, natural
      gas prices, the timing of collections from customers, natural gas purchasing,
      and storage and hedging practices. The company relies on short-term financing
      to
      meet seasonal increases in working capital needs. Cash requirements generally
      increase over the last half of the year due to increases in natural gas
      purchases, gas in storage and accounts receivable. During the first half of
      the
      year, positive cash flow generally results from the sale of gas in storage
      and
      the collection of accounts receivable. This cash is typically used to
      substantially reduce or eliminate short-term borrowings during the first half
      of
      the year. Net cash flow provided from operating activities decreased $38.2
      million to $471.4 million for the nine months ended September 30, 2006 from
      $509.6 million in the year-earlier period.





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





In
      2003,
      Nicor Gas received an income tax refund of approximately $100 million
      attributable to a tax loss carryback associated with a change in tax accounting
      method (which increased its deferred income tax liability), subject to Internal
      Revenue Service (“IRS”) review and approval as part of normal ongoing audits.
      Through December 31, 2004, the total current tax benefits previously recorded
      under this accounting method approximated $135 million (amounts recorded were
      offset by increases to the deferred tax liability with no net effect on reported
      net federal income tax expense). In the third quarter of 2005, the IRS revised
      the regulations pertaining to the aforementioned tax accounting method. The
      new
      regulations require repayment in 2005 and 2006 of amounts previously taken
      as
      current tax deductions. In the second half of 2005 and during the nine months
      ended September 30, 2006, Nicor Gas reclassified income tax expense from
      deferred to current and repaid approximately $67 million and $50 million,
      respectively. The company expects to repay the remaining amounts during the
      fourth quarter of 2006. The anticipated repayment is expected to have no direct
      impact on earnings and no material impact on the company’s financial condition.





**Investing
      activities.** Net
      cash
      flows used for investing activities decreased $30.1 million to $106.4 million
      for the nine months ended September 30, 2006 compared to $136.5 million in
      the
      prior-year period. This decrease is primarily due to reduced capital
      expenditures.





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





*Long-term
      debt.* In
      October 2006, Nicor Gas entered into an agreement for the issuance of $50
      million First Mortgage Bonds at 5.85 percent, due in 2036. The issuance is
      expected to occur, subject to the satisfaction of the conditions in the
      underlying agreements, on the maturity date of the $50 million 5.55 percent
      First Mortgage Bond series due in December 2006.




















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*Short-term
      debt.* In
      October 2006, Nicor Gas established a $400 million, 210-day seasonal revolver,
      which expires in May 2007, to replace the $400 million, 210-day seasonal
      revolver, which expired in April 2006. In September 2005, Nicor Gas and its
      parent company, Nicor Inc. (“Nicor”), 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 $151.0 million, $490.0 million and $31.0 million of
      commercial paper borrowings outstanding at September 30, 2006, December 31,
      2005
      and September 30, 2005, respectively. The company believes it is in compliance
      with all debt covenants and believes it will continue to remain so. The company
      expects that funding from commercial paper and related backup line-of-credit
      agreements will continue to be available in the foreseeable future and
      sufficient to meet estimated cash requirements.





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





**Gas
      in storage.** Gas in
      storage inventory is carried at cost on a last-in, first-out (“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.





At
      September 30, 2006, the company had an inventory decrement of approximately
      5
      Bcf which it believes will not be restored prior to year-end. The liquidated
      inventory was charged to cost of gas at a LIFO cost of $7.82 per Mcf. If the
      company had deemed the decrement to be temporary, it would have charged cost
      of
      gas for the estimated annual replacement cost, currently estimated to be about
      $6.32 per Mcf. Applying LIFO cost in valuing the decrement, as opposed to the
      estimated annual replacement cost, had the effect of increasing the cost of
      gas
      distributed by $7.5 million during 2006. However, since the cost of gas,
      including inventory costs, is charged to customers without markup, subject
      to
      ICC review, this difference had no impact on net income. There was no
      liquidation of any LIFO layers during 2005.





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





*Performance-based
      rate (“PBR”) plan* .
      Nicor
      Gas’ PBR plan for natural gas costs went into effect in 2000 and was terminated
      by the company effective January 1, 2003. Under the PBR plan, Nicor Gas’ total
      gas supply costs were compared to a market-sensitive benchmark. Savings and
      losses relative to the benchmark were determined annually and shared equally
      with sales customers. The PBR is currently under ICC review.

















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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. Parties
      who were plaintiffs in a dismissed class action proceeding against the company
      could potentially intervene in these proceedings. The company has committed
      to
      cooperate fully in the reviews of the PBR plan.





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





In
      response, the Nicor Board of Directors directed the company’s management to,
      among other things, make appropriate adjustments to account for, and fully
      address, the adverse consequences to ratepayers of the items noted in the
      Report, and conduct a detailed study of the adequacy of internal accounting
      and
      regulatory controls . The
      adjustments were made in prior years’ financial statements resulting in a $24.8
      million liability. Included in such $24.8 million liability is a $4.1 million
      loss contingency. A $1.8 million adjustment to the previously recorded
      liability, which is discussed below, was made in 2004 increasing the recorded
      liability to $26.6 million. In addition, Nicor Gas estimates that there is
      $26.9
      million due to the company from the 2002 PBR plan year, which has not been
      recognized in the financial statements due to uncertainties surrounding the
      PBR
      plan. The net of these items and interest income on certain components results
      in a $1.0 million reimbursement the company is seeking as of September 30,
      2006 *,* pending
      resolution of the proceedings discussed below. By the end of 2003, the company
      completed steps to correct the weaknesses and deficiencies identified in the
      detailed study of the adequacy of internal controls.





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





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























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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. Nicor Gas filed
      rebuttal testimony in January 2004, which is consistent with the findings of
      the
      special committee Report. Nicor Gas seeks a reimbursement of approximately
      $1
      million as referenced above. The parties to the ICC Proceedings have agreed
      to a
      stay of the evidentiary hearings on this matter in order 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.





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





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





Nicor
      Gas
      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,
      2006.





*SEC
      and U.S. Attorney Inquiries.* In 2002,
      the staff of the SEC informed the company that the SEC is conducting a formal
      inquiry regarding the PBR plan. A representative of the Office of the United
      States Attorney for the Northern District of Illinois has notified the company
      that that office is conducting an inquiry on the same matter that the SEC is
      investigating, and a grand jury is also reviewing this matter. In April 2004,
      Nicor was advised by the SEC Division of Enforcement that it intended to
      recommend to the SEC that it bring a civil injunctive action against Nicor,
      alleging that Nicor violated Sections 17(a) of the Securities Act of 1933 and
      Sections 10(b) and 13(a) of the Securities Exchange Act of 1934 and Rules 10b-5,
      12b-20, 13a-1 and 13a-13 thereunder. On July 7, 2006, Nicor announced that
      it
      reached a tentative agreement with the SEC Staff in settlement of an anticipated
      civil action to which Nicor and the SEC will be parties. Under the terms of
      the
      tentative settlement, Nicor will be subject to disgorgement of one dollar,
      a
      monetary fine of $10 million and an injunction. Nicor will neither admit nor
      deny any wrongdoing. In July 2006, Nicor deposited the $10 million in escrow
      pending final approval of the tentative settlement by the SEC commissioners
      and
      entry of a final judgment by a federal court. The SEC Staff will submit the
      tentative settlement to the SEC commissioners for approval. The SEC
      commissioners have the authority to approve, modify or reject the tentative
      settlement. Nicor recorded a





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$10
      million charge to its second quarter earnings in connection with this matter.
      As
      the tentative settlement is between Nicor and the SEC Staff, Nicor Gas has
      not
      recorded a liability associated with the outcome of the SEC matter. The company
      is unable to predict the outcome of the separate inquiry by the U.S. Attorney
      or
      the company’s potential exposure related thereto and has not recorded a
      liability associated with the outcome of that matter.





*Mercury.* Future
      operating results may be impacted by adjustments to the company’s estimated
      mercury liability or by related recoveries. Additional information about mercury
      contingencies is presented in Item 1 - Notes to the Condensed Consolidated
      Financial Statements - Note 13 - Contingencies - Mercury.





*Manufactured
      gas plant sites.* The
      company is conducting environmental investigations and remedial activities
      at
      former manufactured gas plant sites. Additional information about these sites
      is
      presented in Item 1 - Notes to the Condensed Consolidated Financial Statements
      -
      Note 13 - Contingencies - Manufactured Gas Plant Sites.





*Other
      contingencies.* **** The
      company is involved in legal or administrative proceedings before various courts
      and agencies with respect to general claims, rates, taxes, environmental, gas
      cost prudence reviews and other matters. See Item 1 - Notes to the Condensed
      Consolidated Financial Statements - Note 2 - Accounting Policies - Income and
      Other Taxes and Note 13 - Contingencies.





**CRITICAL
      ACCOUNTING ESTIMATES**





See
      Item
      7 - Management’s Discussion and Analysis of Financial Condition and Results of
      Operations - Critical Accounting Estimates in Nicor Gas’ 2005 Annual Report on
      Form 10-K for a discussion of the company’s critical accounting estimates. There
      have been no material changes to these estimates.





**NEW
      ACCOUNTING PRONOUNCEMENTS**





In
      the
      third quarter of 2006, the Financial Accounting Standards Board (“FASB”) issued
      Interpretation No. 48, *Accounting
      for Uncertainty in Income Taxes* ,
      Statement of Financial Accounting Standard (“SFAS”) No. 157, *Fair
      Value Measurements,* and SFAS
      No. 158, *Employers’
      Accounting for Defined Benefit Pension and Other Postretirement
      Plans* .
      For
      more information, see Item 1 - Notes to the Condensed Consolidated Financial
      Statements - Note 3 - New Accounting Pronouncements.





**CAUTION
      CONCERNING FORWARD-LOOKING STATEMENTS**





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























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





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





**Item
      3.****Quantitative
      and Qualitative Disclosures About Market Risk**





The
      company is exposed to market risk in the normal course of its business
      operations, including the risk of loss arising from adverse changes in natural
      gas commodity prices and interest rates.





There
      has
      been no material change in the company's exposure to market risk since the
      filing of the 2005 Annual Report on Form 10-K.





**Item
      4.********Controls
      and Procedures**





The
      company carried out an evaluation under the supervision and with the
      participation of the company’s management, including its Chief Executive Officer
      and Chief Financial Officer, of the effectiveness of the design and operation
      of
      the company’s disclosure controls and procedures as of the end of the period
      covered by this Quarterly Report on Form 10-Q (the “Evaluation”).





In
      designing and evaluating the disclosure controls and procedures, management
      recognizes that any disclosure controls and procedures, no matter how well
      designed and operated, can provide only reasonable assurance of achieving the
      desired control objectives, and management is required to apply its judgment
      in
      evaluating the cost-benefit relationship of possible disclosure controls and
      procedures. Based on the Evaluation, the company’s Chief Executive Officer and
      Chief Financial Officer concluded that the company’s disclosure controls and
      procedures, as of the end of the period covered by this Quarterly Report on
      Form
      10-Q, were effective at the reasonable assurance level to ensure that
      information required to be disclosed by the company in reports that it files
      or
      submits under the Securities Exchange Act of 1934 is recorded, processed,
      summarized and reported within the time periods specified in United States
      Securities and Exchange Commission rules and forms.





There
      has
      been no change in the company’s internal controls over financial reporting
      during the company’s most recent fiscal quarter that has materially affected, or
      is reasonably likely to materially affect, the company’s internal control over
      financial reporting. In the second quarter of 2006, the company disclosed that
      it completed the implementation of a new customer care and billing
      system.





**PART
      II - OTHER INFORMATION**





**Item
      1.****Legal
      Proceedings**




See
      Item
      2 - Management’s Discussion and Analysis of Financial Condition and Results of
      Operations - Contingencies and Item 1 - Notes to the Condensed Consolidated
      Financial Statements - Note 11 - Rate Proceeding and Note 13 - Contingencies,
      which are incorporated herein by reference, for a discussion of the company’s
      contingencies.








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**Item
      6.****Exhibits**





ExhibitNumber
            
            Description
                of Document3.01
            *
            Restated
                Articles of Incorporation of the company as filed with the Illinois
                Secretary of State on July 21, 2006 (File No. 1-7296, Form 10-Q for
                June
                30, 2006, Exhibit 3.01).3.02
            *
            By-Laws
                of the company as amended by the company’s Board of Directors on January
                15, 2004. (File No. 1-7296, Form 10-K for 2003, Exhibit
                3.03.)10.01
            
            210-Day
                Credit Agreement dated as of
                October 26, 200610.02
            
            Second
                Amendment to the 5-Year
                Credit Agreement dated as of October 26, 2006.12.01
            
            Computation
                of Consolidated Ratio of Earnings to
                Fixed Charges.31.1
            
            Rule
                13a-14(a)/15d-14(a)
                Certification.31.2
            
            Rule
                13a-14(a)/15d-14(a)
                Certification.32.1
            
            Section
                1350
                Certification.32.2
            
            Section
                1350
                Certification.







*  These
      exhibits have been previously filed with the United States Securities and
      Exchange Commission (“SEC”) as exhibits to registration statements or to other
      filings with the SEC and are incorporated herein as exhibits by reference.
      The
      file number and exhibit number of each such exhibit, where applicable, are
      stated, in parentheses, in the description of such exhibit.



















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**Signature**





Pursuant
      to the requirements of the Securities Exchange Act of 1934, the registrant
      has
      duly caused this report to be signed on its behalf by the undersigned thereunto
      duly authorized.














Nicor
                Gas CompanyNovember
                1, 2006
            
            /s/
                KAREN K. PEPPING(Date)
            
            Karen
                K. PeppingVice
                President and Controller(Principal
                Accounting Officer andDuly
                Authorized Officer)










































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