**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 June 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 six months endedJune
                  30, 2006 and 2005Condensed
                  Consolidated Statements of Cash
                  Flows:
              2Six
                  months endedJune
                  30, 2006 and 2005Condensed
                  Consolidated Balance
                  Sheets:
              3June
                  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
              15Item
                  3.
              Quantitative
                  and Qualitative Disclosures About Market
                  Risk
              23Item
                  4.
              Controls
                  and Procedures
              23**Part
                  II - Other Information**Item
                  1.
              Legal
                  Proceedings
              24Item
                  6.
              Exhibits
              24Signature
              25
 
 
 
 
 
 
 
 
 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.
 
 **FERC.** Federal
        Energy Regulatory Commission, the agency that regulates the interstate
        transportation of natural gas, oil and electricity.
 
 **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.
 
 **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**
            
            **Six
                months ended****June
                30**
            
            **June
                30****2006**
            
            2005
            
            **2006**
            
            2005Operating
                revenues (includes revenue taxesof
                $26.0, $27.4, $98.6 and $99.6, respectively)
            
            **$**
            **338.1**
            
            $
            372.2
            
            **$**
            **1,548.9**
            
            $
            1,451.1Operating
                expensesCost
                of gas
            
            
            **194.1**
            
            
            230.6
            
            
            **1,150.8**
            
            
            1,067.4Operating
                and maintenance
            
            
            **60.5**
            
            
            58.5
            
            
            **142.8**
            
            
            126.8Depreciation
            
            
            **40.1**
            
            
            38.6
            
            
            **80.2**
            
            
            77.3Taxes,
                other than income taxes
            
            
            **29.4**
            
            
            31.4
            
            
            **106.2**
            
            
            107.4Income
                tax expense, net
            
            
            **.5**
            
            
            1.6
            
            
            **16.5**
            
            
            17.4Mercury-related
                costs (recoveries), net
            
            
            **.2**
            
            
            -
            
            
            **(3.6**
            **)**
            
            .1**324.8**
            
            
            360.7
            
            
            **1,492.9**
            
            
            1,396.4Operating
                income
            
            
            **13.3**
            
            
            11.5
            
            
            **56.0**
            
            
            54.7Other
                income (expense), netProperty
                sale gains
            
            
            **2.5**
            
            
            .1
            
            
            **2.6**
            
            
            .1Interest
                income
            
            
            **3.2**
            
            
            2.1
            
            
            **3.9**
            
            
            2.4Other
                income (expense), net
            
            
            **(.1**
            **)**
            
            (.1
            )
            
            **(.3**
            **)**
            
            (.3
            )Income
                taxes on other income
            
            
            **(2.3**
            **)**
            
            (.8
            )
            
            **(2.6**
            **)**
            
            (.8
            )**3.3**
            
            
            1.3
            
            
            **3.6**
            
            
            1.4Interest
                expenseInterest
                on debt, net of amounts capitalized
            
            
            **8.1**
            
            
            8.1
            
            
            **19.3**
            
            
            17.9Other
            
            
            **.3**
            
            
            1.1
            
            
            **1.9**
            
            
            2.1**8.4**
            
            
            9.2
            
            
            **21.2**
            
            
            20.0Net
                income
            
            
            **8.2**
            
            
            3.6
            
            
            **38.4**
            
            
            36.1Dividends
                on preferred stock
            
            
            **-**
            
            
            -
            
            
            **-**
            
            
            (.1
            )Earnings
                applicable to common stock
            
            **$**
            **8.2**
            
            $
            3.6
            
            **$**
            **38.4**
            
            $
            36.0The
                accompanying notes are an integral part of these
                statements.




1


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          of Contents


**Nicor
                Gas Company****Condensed
                Consolidated Statements of Cash Flows
                (Unaudited)****(millions)****Six
                months ended****June
                30****2006**
            
            2005Operating
                activitiesNet
                income
            
            **$**
            **38.4**
            
            $
            36.1Adjustments
                to reconcile net income to net cash flowprovided
                from operating activities:Depreciation
            
            
            **80.2**
            
            
            77.3Deferred
                income tax benefit
            
            
            **(31.8**
            **)**
            
            (.7
            )Gain
                on sale of property, plant and equipment
            
            
            **(2.6**
            **)**
            
            (.1
            )Changes
                in assets and liabilities:Receivables,
                less allowances
            
            
            **479.1**
            
            
            258.7Gas
                in storage
            
            
            **213.7**
            
            
            178.5Deferred/accrued
                gas costs
            
            
            **(56.6**
            **)**
            
            24.7Prepaid
                pension costs
            
            
            **(4.9**
            **)**
            
            (3.1
            )Other
                assets
            
            
            **22.9**
            
            
            11.0Accounts
                payable
            
            
            **(197.3**
            **)**
            
            (15.5
            )Temporary
                last-in, first-out inventory liquidation
            
            
            **243.0**
            
            
            171.4Other
                liabilities
            
            
            **(.5**
            **)**
            
            (23.6
            )Other
                items
            
            
            **(5.6**
            **)**
            
            1.5Net
                cash flow provided from operating activities
            
            
            **778.0**
            
            
            716.2Investing
                activitiesCapital
                expenditures
            
            
            **(74.6**
            **)**
            
            (89.4
            )Increase
                in deposits in Nicor cash management pool
            
            
            **(136.0**
            **)**
            
            (152.9
            )Net
                proceeds from sale of property, plant and equipment
            
            
            **2.8**
            
            
            .1Other
                investing activities
            
            
            **3.7**
            
            
            (.1
            )Net
                cash flow used for investing activities
            
            
            **(204.1**
            **)**
            
            (242.3
            )Financing
                activitiesDisbursements
                to retire long-term obligations
            
            
            **(.5**
            **)**
            
            (.5
            )Net
                repayments of commercial paper with maturities of90
                days or less
            
            
            **(490.0**
            **)**
            
            (375.0
            )Dividends
                paid
            
            
            **(23.0**
            **)**
            
            (19.0
            )Net
                cash flow used for financing activities
            
            
            **(513.5**
            **)**
            
            (394.5
            )Net
                increase in cash and cash equivalents
            
            
            **60.4**
            
            
            79.4Cash
                and cash equivalents, beginning of period
            
            
            **10.2**
            
            
            -Cash
                and cash equivalents, end of period
            
            **$**
            **70.6**
            
            $
            79.4The
                accompanying notes are an integral part of these
                statements.




2


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          of Contents


**Nicor
                Gas Company****Condensed
                Consolidated Balance Sheets
                (Unaudited)****(millions)****June
                30**
            
            December
                31
            
            June
                30**2006**
            
            2005
            
            2005**Assets**Gas
                distribution plant, at cost
            
            **$**
            **4,087.7**
            
            $
            4,043.2
            
            $
            3,897.1Less
                accumulated depreciation
            
            
            **1,537.4**
            
            
            1,513.1
            
            
            1,446.3Gas
                distribution plant, net
            
            
            **2,550.3**
            
            
            2,530.1
            
            
            2,450.8Current
                assetsCash
                and cash equivalents
            
            
            **70.6**
            
            
            10.2
            
            
            79.4Deposits
                in Nicor cash management pool
            
            
            **136.0**
            
            
            -
            
            
            153.0Receivables,
                less allowances of $38.4,$30.1
                and $29.1, respectively
            
            
            **285.2**
            
            
            753.0
            
            
            234.2Receivables
                - affiliates
            
            
            **7.2**
            
            
            18.5
            
            
            7.7Gas
                in storage, at last-in, first-out cost
            
            
            **7.3**
            
            
            221.0
            
            
            10.5Deferred
                income taxes
            
            
            **4.7**
            
            
            -
            
            
            42.1Other
            
            
            **33.5**
            
            
            53.1
            
            
            39.1Total
                current assets
            
            
            **544.5**
            
            
            1,055.8
            
            
            566.0Prepaid
                pension costs
            
            
            **192.5**
            
            
            187.6
            
            
            184.6Other
                assets
            
            
            **45.9**
            
            
            46.8
            
            
            52.1Total
                assets
            
            **$**
            **3,333.2**
            
            $
            3,820.3
            
            $
            3,253.5**Capitalization
                and Liabilities**CapitalizationLong-term
                obligationsLong-term
                bonds and notes, net of unamortized discount
            
            **$**
            **447.3**
            
            $
            445.8
            
            $
            495.5Mandatorily
                redeemable preferred stock
            
            
            **3.6**
            
            
            4.1
            
            
            4.1Total
                long-term obligations
            
            
            **450.9**
            
            
            449.9
            
            
            499.6Preferred
                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
            
            
            **497.2**
            
            
            470.7
            
            
            482.4Accumulated
                other comprehensive loss, net
            
            
            **(.3**
            **)**
            
            (.3
            )
            
            (.8
            )Total
                common equity
            
            
            **681.2**
            
            
            654.7
            
            
            665.9Total
                capitalization
            
            
            **1,133.5**
            
            
            1,106.0
            
            
            1,166.9Current
                liabilitiesLong-term
                obligations due within one year
            
            
            **50.5**
            
            
            50.5
            
            
            .5Short-term
                borrowings
            
            
            **-**
            
            
            490.0
            
            
            -Accounts
                payable
            
            
            **346.4**
            
            
            543.7
            
            
            390.5Temporary
                last-in, first-out inventory liquidation
            
            
            **243.0**
            
            
            -
            
            
            171.4Accrued
                gas costs
            
            
            **166.7**
            
            
            223.3
            
            
            92.9Deferred
                income taxes
            
            
            **1.2**
            
            
            24.4
            
            
            -Dividends
                payable
            
            
            **-**
            
            
            11.0
            
            
            -Other
            
            
            **63.1**
            
            
            58.4
            
            
            36.1Total
                current liabilities
            
            
            **870.9**
            
            
            1,401.3
            
            
            691.4Deferred
                credits and other liabilitiesRegulatory
                retirement cost liability
            
            
            **652.2**
            
            
            631.7
            
            
            730.5Deferred
                income taxes
            
            
            **293.9**
            
            
            296.1
            
            
            439.0Asset
                retirement obligation
            
            
            **167.2**
            
            
            164.0
            
            
            -Regulatory
                income tax liability
            
            
            **39.6**
            
            
            41.3
            
            
            43.2Unamortized
                investment tax credits
            
            
            **30.7**
            
            
            31.7
            
            
            32.8Other
            
            
            **145.2**
            
            
            148.2
            
            
            149.7Total
                deferred credits and other liabilities
            
            
            **1,328.8**
            
            
            1,313.0
            
            
            1,395.2Commitments
                and contingenciesTotal
                capitalization and liabilities
            
            **$**
            **3,333.2**
            
            $
            3,820.3
            
            $
            3,253.5The
                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 applying a last-in, first-out (“LIFO”)
      method on a calendar-year basis. For interim periods, the difference between
      estimated replacement cost and the LIFO cost for quantities of gas temporarily
      withdrawn from storage is recorded in cost of gas and in current liabilities
      as
      a temporary LIFO liquidation.





**Regulatory
      assets and liabilities.** Nicor
      Gas is regulated by the Illinois Commerce Commission (“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):





**June
                30**
            
            December
                31
            
            June
                30**2006**
            
            2005
            
            2005**Regulatory
                assets**Deferred
                environmental costs
            
            **$**
            **13.0**
            
            $
            15.1
            
            $
            17.7Unamortized
                losses on reacquired debt
            
            
            **18.2**
            
            
            18.7
            
            
            19.3Deferred
                rate case costs
            
            
            **3.2**
            
            
            3.5
            
            
            3.6Other
            
            
            **2.5**
            
            
            .3
            
            
            .3**$**
            **36.9**
            
            $
            37.6
            
            $
            40.9


**Regulatory
                liabilities**Regulatory
                retirement cost liability - current
            
            **$**
            **9.0**
            
            $
            9.0
            
            $
            12.1Regulatory
                retirement cost liability - noncurrent
            
            
            **652.2**
            
            
            631.7
            
            
            730.5Accrued
                gas costs
            
            
            **166.7**
            
            
            223.3
            
            
            92.9Regulatory
                income tax liability
            
            
            **39.6**
            
            
            41.3
            
            
            43.2Other
            
            
            **.1**
            
            
            1.8
            
            
            5.0**$**
            **867.6**
            
            $
            907.1
            
            $
            883.7





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.





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**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 six months ended June 30, 2006 were $25.0 million
      and
      $96.4 million, respectively, and $26.7 million and $97.3 million, respectively,
      for the same periods ending June 30, 2005.





**Income
      and other taxes.** The
      effective income tax rate for the quarter ended June 30, 2006 decreased to
      25.6
      percent from 41.4 percent for the quarter ended June 30, 2005. For the six
      months ended June 30, 2006, the effective income tax rate decreased to 33.3
      percent from 33.6 percent for the prior year period. The second quarter change
      in the effective income tax rate is primarily due to favorable adjustments
      associated with tax audits (which occur in the ordinary course of business).
      These quarterly effective income tax rates compared to the year-to-date
      effective income tax rates reflect changes to forecasted annual income in the
      second quarter of each year. Such changes are not significant for the
      year-to-date periods, but they have a disproportionate impact on the second
      quarter effective income tax rate as the income before income taxes is
      relatively low.





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 June 30, 2006, December 31, 2005 and June 30, 2005,
      the company had accrued approximately $11.5 million, $9.0 million and $6.6
      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 the first half of 2006,
      Nicor Gas reclassified income tax expense from deferred to current and repaid
      approximately $67 million and $34 million, respectively. The company expects
      to
      repay the remaining approximately $34 million during the second half of 2006.  The
      anticipated repayment is expected to have no direct impact on earnings and
      no
      material impact on the company’s financial condition.





**3.**  **NEW
      ACCOUNTING PRONOUNCEMENT**





**Uncertain
      tax positions.** In
      July
      2006, the Financial Accounting Standards Board 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.











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          of Contents




**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 six months ended June 30, 2006 (in millions):





Beginning
                of period
            
            **$**
            **164.4**Liabilities
                incurred during the period
            
            
            **1.1**Liabilities
                settled during the period
            
            
            **(1.4**
            **)**Accretion
            
            
            **4.7**End
                of period
            
            **$**
            **168.8**





Substantially
      all of the ARO is classified as a noncurrent liability.





**5.**  **SHORT-TERM
      DEBT**





In
      September 2005, Nicor Gas and its parent company, Nicor Inc. (“Nicor”),
      established two revolving credit facilities totaling $1 billion with major
      domestic and foreign banks, which replaced $900 million of revolving facilities.
      These replacement facilities, which serve as backup for the issuance of
      commercial paper, consist of a $600 million, five-year revolver, expiring
      September 2010, available to Nicor and Nicor Gas, and a $400 million, 210-day
      seasonal revolver, which expired in April 2006 and was available to Nicor Gas.
      The company had no commercial paper borrowings outstanding at June 30, 2006
      and
      2005, and $490 million of commercial paper borrowings outstanding at December
      31, 2005. The company believes it is in compliance with all debt covenants
      at
      June 30, 2006.





**6.**  **ACCRUED
      UNBILLED REVENUES**





Receivables
      include accrued unbilled revenues of $45.9 million, $300.4 million and $43.6
      million at June 30, 2006, December 31, 2005 and June 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 June 30, 2006, December 31, 2005 and June
      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 $503 million, $525 million and $549 million at June 30, 2006,
      December 31, 2005 and June 30, 2005, respectively.





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):











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**June
                30**
            
            December
                31
            
            June
                30**2006**
            
            2005
            
            2005Current
                other assets
            
            **$**
            **5.0**
            
            $
            25.7
            
            $
            13.3Noncurrent
                other assets
            
            
            **.1**
            
            
            1.0
            
            
            1.0**$**
            **5.1**
            
            $
            26.7
            
            $
            14.3Current
                other liabilities
            
            **$**
            **20.7**
            
            $
            .8
            
            $
            -Noncurrent
                other liabilities
            
            
            **2.8**
            
            
            .1
            
            
            -**$**
            **23.5**
            
            $
            .9
            
            $
            -





Nicor
      Gas
      maintains a margin account related to financial derivative transactions. At
      June
      30, 2006, December 31, 2005 and June 30, 2005, the balance of this account
      was
      $21.7 million, $33.7 million and $19.0 million, 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 gas distribution operating and maintenance expense.
      Net
      periodic benefit cost (credit) included the following components (in
      millions):





Pension
                benefits
            
            Health
                care and
              other
                benefits**2006**
            
            2005
            
            **2006**
            
            2005**Three
                months ended June 30**Service
                cost
            
            **$**
            **2.4**
            
            $
            2.3
            
            **$**
            **.6**
            
            $
            .7Interest
                cost
            
            
            **3.7**
            
            
            3.9
            
            
            **2.6**
            
            
            2.6Expected
                return on plan assets
            
            
            **(8.7**
            **)**
            
            (8.3
            )
            
            **-**
            
            
            (.2
            )Recognized
                net actuarial loss
            
            
            **-**
            
            
            .4
            
            
            **1.2**
            
            
            1.1Amortization
                of prior service cost
            
            
            **.2**
            
            
            .2
            
            
            **-**
            
            
            -Net
                periodic benefit cost (credit)
            
            **$**
            **(2.4**
            **)**
            $
            (1.5
            )
            **$**
            **4.4**
            
            $
            4.2**Six
                months ended June 30**Service
                cost
            
            **$**
            **4.7**
            
            $
            4.7
            
            **$**
            **1.2**
            
            $
            1.3Interest
                cost
            
            
            **7.4**
            
            
            7.8
            
            
            **5.2**
            
            
            5.2Expected
                return on plan assets
            
            
            **(17.4**
            **)**
            
            (16.6
            )
            
            **(.1**
            **)**
            
            (.5
            )Recognized
                net actuarial loss
            
            
            **.1**
            
            
            .7
            
            
            **2.4**
            
            
            2.4Amortization
                of prior service cost
            
            
            **.3**
            
            
            .3
            
            
            **-**
            
            
            -Net
                periodic benefit cost (credit)
            
            **$**
            **(4.9**
            **)**
            $
            (3.1
            )
            **$**
            **8.7**
            
            $
            8.4





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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 $1.4 million and $2.7 million for the three and
      six months ended June 30, 2006, respectively, and $0.6 million and $1.2 million,
      respectively, for the corresponding prior-year periods.





**9.**  **COMPREHENSIVE
      INCOME**





Total
      comprehensive income, as defined by Statement of Financial Accounting Standard
      ("SFAS") No. 130, *Reporting
      Comprehensive Income* ,
      is
      equal to net income plus other comprehensive income and is as follows (in
      millions):





Three
                months ended
            
            Six
                months endedJune
                30
            
            June
                30**2006**
            
            2005
            
            **2006**
            
            2005Net
                Income
            
            **$**
            **8.2**
            
            $
            3.6
            
            **$**
            **38.4**
            
            $
            36.1Other
                comprehensive income, after tax
            
            
            **-**
            
            
            .8
            
            
            **-**
            
            
            .7Total
                comprehensive income
            
            **$**
            **8.2**
            
            $
            4.4
            
            **$**
            **38.4**
            
            $
            36.8





Net
      other
      comprehensive income 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 charges Nicor Gas and its other wholly owned subsidiaries for
      the cost of corporate overheads. For the three and six months ended June 30,
      2006, Nicor Gas had net charges to affiliates of $1.7 million and $7.4 million,
      respectively. For the three and six months ended June 30, 2005, Nicor Gas had
      net charges to affiliates of $1.7 million and $6.0 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. 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.

















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Nicor
      Gas
      had deposits in the Nicor cash management pool, due on demand from Nicor, of
      $136.0 million, zero and $153.0 million at June 30, 2006, December 31, 2005
      and
      June 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 six months ended June 30, 2006, Nicor Gas recorded interest income of $1.5
      million from these deposits. For the three and six months ended June 30, 2005,
      interest income was $1.1 million.





Nicor
      Solutions, a subsidiary 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 six months ended June 30, 2006, Nicor Gas recorded revenues of $12.9 million
      and $53.4 million, respectively, associated with the payments Nicor Solutions
      makes to Nicor Gas on behalf of its customers. For the three and six months
      ended June 30, 2005, such revenues were $13.6 million and $44.5 million,
      respectively.





Nicor
      Gas
      enters into routine transactions with Nicor Enerchange, a wholesale natural
      gas
      marketing subsidiary 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 six months ended June 30, 2006, net
      charges from Nicor Enerchange were $3.0 million and $24.3 million, respectively.
      For the three and six months ended June 30, 2005, net charges from Nicor
      Enerchange were insignificant and $8.4 million, respectively.





Horizon
      Pipeline, a 50-percent-owned joint venture of Nicor, charged Nicor Gas $2.6
      million and $5.2 million for the three and six months ended June 30, 2006,
      respectively, for natural gas transportation under rates that have been accepted
      by the Federal Energy Regulatory Commission. For the three and six months ended
      June 30, 2005, Horizon Pipeline charged Nicor Gas $2.6 million and $5.2 million,
      respectively.





EN
      Engineering, a 50-percent-owned joint venture of Nicor, charged Nicor Gas $0.9
      million and $1.8 million for the three and six months ended June 30, 2006,
      respectively, for engineering and corrosion services. For the three and six
      months ended June 30, 2005, Nicor Gas was charged $0.9 million and $2.1 million,
      respectively, for these services.




Key
        executives and managerial employees of Nicor Gas participate in Nicor’s
        stock-based compensation plans. For the three and six-month periods ended
        June
        30, 2006, Nicor Gas recognized $0.8 million and $1.4 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.
















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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. Certain
      parties, including Nicor Gas, have appealed the ICC’s rate case decision to the
      state appellate courts.





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 six months ended June 30, 2006, storage-related
      gas
      costs in operating and maintenance expense totaled $2.0 million and $14.4
      million, respectively. Such costs totaled $1.1 million 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.





**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.














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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.





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 June 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
      interveners 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 June 30,
      2006.





**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











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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 has
      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 27
      households.





As
      of
      June 30, 2006, Nicor Gas had remaining an estimated liability of $16.1 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 gas distribution 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.





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








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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
      June 30, 2006, the company had recorded a liability in connection with these
      matters of $13.8 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 June 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.





**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.

















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**Item
      2.****Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations**





The
      following discussion should be read in conjunction with the Management’s
      Discussion and Analysis section of the 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 six-month periods ended June 30, 2006 and 2005 (in
      millions):




Three
                months ended
            
            Six
                months endedJune
                30
            
            June
                30**2006**
            
            2005
            
            **2006**
            
            2005Operating
                income
            
            **$**
            **13.3**
            
            $
            11.5
            
            **$**
            **56.0**
            
            $
            54.7Net
                income
            
            
            **8.2**
            
            
            3.6
            
            
            **38.4**
            
            
            36.1





Net
      income for the three and six months ended June 30, 2006, compared with the
      year-earlier periods increased $4.6 million and $2.3 million, respectively,
      due
      primarily to a second quarter 2006 pretax gain on the sale of property ($2.5
      million) and higher operating income.





Operating
      income increased $1.8 million and $1.3 million for the three and six months
      ended June 30, 2006, respectively, compared with the year-earlier periods due
      primarily to the positive effects of higher gas distribution margin ($4.1
      million and $15.3 million pretax increases, respectively) and the positive
      impact of favorable adjustments associated with tax audits (approximately $1
      million after-tax), partially offset by higher operating and maintenance
      expenses ($2.0 million and $16.0 million pretax increases, respectively) and
      higher depreciation expense ($1.5 million and $2.9 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





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Nicor
      Gas’ PGA rider, under normal weather conditions, 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. Certain parties, including Nicor Gas, have appealed the ICC’s rate
      case decision to the state appellate courts.





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 six months ended June 30, 2006, storage-related
      gas
      costs in operating and maintenance expense totaled $2.0 million and $14.4
      million, respectively. Such costs totaled $1.1 million 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 second
      quarter of 2006 compared with a year ago, revenues decreased $34.1 million
      due
      to lower natural gas costs (approximately $55 million decrease), partially
      offset by the impact of the rate order tariffs (approximately $6 million).
      For
      the 2006 year-to-date period compared with a year ago, gas distribution revenues
      increased $97.8 million due to higher natural gas costs (approximately $224
      million increase) and the impact of the rate order tariffs (approximately $25
      million), partially offset by the negative impact of warmer weather than the
      corresponding period in 2005 (approximately $140 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
            
            Six
                months endedJune
                30
            
            June
                30**2006**
            
            2005
            
            **2006**
            
            2005Revenues
            
            **$**
            **338.1**
            
            $
            372.2
            
            **$**
            **1,548.9**
            
            $
            1,451.1Cost
                of gas
            
            
            **(194.1**
            **)**
            
            (230.6
            )
            
            **(1,150.8**
            **)**
            
            (1,067.4
            )Revenue
                tax expense
            
            
            **(25.0**
            **)**
            
            (26.7
            )
            
            **(96.4**
            **)**
            
            (97.3
            )Margin
            
            **$**
            **119.0**
            
            $
            114.9
            
            **$**
            **301.7**
            
            $
            286.4





Margin
      increased $4.1 million in the second quarter of 2006 compared with the
      corresponding prior-year period due primarily to higher average rates
      (approximately $5 million increase) driven by the base rate increase
      (approximately $6 million assuming normal weather). Year-to-date 2006 margin
      increased $15.3 million compared with the corresponding prior-year period due
      primarily to higher average rates (approximately $30 million increase) driven
      primarily by the base rate increase (approximately $25 million assuming normal
      weather), partially offset by the negative impact of warmer weather than in
      2005
      (approximately $10 million decrease) and lower demand unrelated to weather
      (approximately $5 million decrease).





**Operating
      and maintenance expense.** Operating and maintenance expense increased **** $2.0
      million to $60.5 million in the second quarter of 2006 from $58.5 million in
      the
      prior-year period due primarily to higher company use gas ($2.2 million
      increase) and storage-related gas costs ($2.0 million increase), partially
      offset by lower claims arising from normal operations ($1.6 million decrease).
      Year-to-date operating and maintenance expense increased $16.0 million to $142.8
      million from $126.8 million in the





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prior-year
      period due primarily to higher storage-related gas costs ($14.4 million
      increase) and company use gas ($6.9 million increase), partially offset by
      lower
      payroll and benefit-related costs ($3.8 million decrease), and lower claims
      arising from normal operations ($3.7 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 approximated $1.1 million and $11.1 million
      in
      the three and six-month periods ended June 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. During the second quarter of 2006, Nicor Gas realized a $2.5 million
      pretax gain on the sale of property. The company continues to assess its
      ownership of real estate holdings.





**Interest
      income.** Interest
      income increased $1.1 million and $1.5 million for the three and six-month
      periods ended June 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 June 30, 2006 decreased to
      25.6
      percent from 41.4 percent for the quarter ended June 30, 2005. For the six
      months ended June 30, 2006, the effective tax rate decreased to 33.3 percent
      from 33.6 percent for the prior year period. The second quarter change in the
      effective tax rate is primarily due to favorable adjustments associated with
      tax
      audits (which occur in the ordinary course of business). These quarterly
      effective tax rates compared to the year-to-date effective tax rates reflect
      changes to forecasted annual income in the second quarter of each year. Such
      changes are not significant for the year-to-date periods, but they have a
      disproportionate impact on the second quarter effective tax rate as the income
      before income taxes is relatively low.





**Interest
      expense.** Interest
      expense of $8.4 million in the second quarter of 2006 decreased $0.8 million
      from the corresponding 2005 period due to lower estimated interest on income
      tax
      matters ($0.9 million decrease). Interest  expense
      of $21.2 million for the six-month period ended June 30, 2006 increased $1.2
      million over the corresponding prior-year period due primarily to higher average
      borrowing levels ($1.5 million increase), partially offset by lower estimated
      interest on income tax matters ($0.6 million decrease).























17


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**Nicor
                  Gas Company****Operating
                  Statistics****Three
                  months ended**
              
              **Six
                  months ended****June
                  30**
              
              **June
                  30****2006**
              
              2005
              
              **2006**
              
              2005**Operating
                  revenues**(millions)SalesResidential
              
              **$**
              **217.8**
              
              $
              239.7
              
              **$**
              **1,070.7**
              
              $
              988.3Commercial
              
              
              **45.8**
              
              
              52.9
              
              
              **245.4**
              
              
              219.0Industrial
              
              
              **4.1**
              
              
              6.7
              
              
              **29.2**
              
              
              30.6**267.7**
              
              
              299.3
              
              
              **1,345.3**
              
              
              1,237.9TransportationResidential
              
              
              **6.5**
              
              
              6.2
              
              
              **15.8**
              
              
              14.3Commercial
              
              
              **17.8**
              
              
              14.8
              
              
              **43.0**
              
              
              39.5Industrial
              
              
              **8.4**
              
              
              8.6
              
              
              **18.4**
              
              
              19.0Other
              
              
              **.5**
              
              
              2.5
              
              
              **.9**
              
              
              7.6**33.2**
              
              
              32.1
              
              
              **78.1**
              
              
              80.4Other
                  revenuesRevenue
                  taxes
              
              
              **26.0**
              
              
              27.4
              
              
              **98.6**
              
              
              99.6Environmental
                  cost recovery
              
              
              **1.3**
              
              
              2.7
              
              
              **6.4**
              
              
              14.5Chicago
                  Hub
              
              
              **3.3**
              
              
              3.3
              
              
              **5.8**
              
              
              5.2Other
              
              
              **6.6**
              
              
              7.4
              
              
              **14.7**
              
              
              13.5**37.2**
              
              
              40.8
              
              
              **125.5**
              
              
              132.8**$**
              **338.1**
              
              $
              372.2
              
              **$**
              **1,548.9**
              
              $
              1,451.1**Deliveries**(Bcf)SalesResidential
              
              
              **24.7**
              
              
              22.9
              
              
              **107.7**
              
              
              119.2Commercial
              
              
              **5.7**
              
              
              5.3
              
              
              **24.7**
              
              
              26.4Industrial
              
              
              **.5**
              
              
              .7
              
              
              **3.0**
              
              
              3.7**30.9**
              
              
              28.9
              
              
              **135.4**
              
              
              149.3TransportationResidential
              
              
              **2.2**
              
              
              2.9
              
              
              **9.5**
              
              
              11.6Commercial
              
              
              **14.5**
              
              
              13.2
              
              
              **48.3**
              
              
              52.0Industrial
              
              
              **21.4**
              
              
              25.7
              
              
              **52.1**
              
              
              59.6**38.1**
              
              
              41.8
              
              
              **109.9**
              
              
              123.2**69.0**
              
              
              70.7
              
              
              **245.3**
              
              
              272.5**Customers
                  at end of period**(thousands)SalesResidential
              
              
              **1,804.0**
              
              
              1,774.7Commercial
              
              
              **122.7**
              
              
              117.9Industrial
              
              
              **7.3**
              
              
              7.3**1,934.0**
              
              
              1,899.9TransportationResidential
              
              
              **153.4**
              
              
              160.9Commercial
              
              
              **57.1**
              
              
              58.1Industrial
              
              
              **5.6**
              
              
              6.0**216.1**
              
              
              225.0**2,150.1**
              
              
              2,124.9**Other
                  statistics**Degree
                  days
              
              
              **560**
              
              
              580
              
              
              **3,217**
              
              
              3,546(Warmer)
                  than normal*
              
              
              **(18**
              **)%**
              
              (16
              )%
              
              **(13**
              **)%**
              
              (4
              )%Average
                  gas cost per Mcf sold
              
              **$**
              **6.22**
              
              $
              7.85
              
              **$**
              **8.46**
              
              $
              7.08*
                  Normal weather for Nicor Gas' service territory, for purposes of
                  this
                  report, is considered to be 5,830degree
                  days per year.




18


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**FINANCIAL
      CONDITION AND LIQUIDITY**





**Operating
      cash flows.** 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 increased $61.8
      million to $778.0 million for the six months ended June 30, 2006 from $716.2
      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 the first half of 2006,
      Nicor Gas reclassified income tax expense from deferred to current and repaid
      approximately $67 million and $34 million, respectively. The company expects
      to
      repay the remaining approximately $34 million during the second half 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 $38.2 million to $204.1 million
      for the six months ended June 30, 2006 compared to $242.3 million in the
      prior-year period. This decrease largely reflects a lower level of deposits
      in
      the Nicor cash management pool and 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.





*Short-term
      debt.* In
      September 2005, Nicor Gas and its parent company, Nicor Inc. (“Nicor”),
      established two revolving credit facilities totaling $1 billion with major
      domestic and foreign banks, which replaced $900 million of revolving facilities.
      These replacement facilities, which serve as backup for the issuance of
      commercial paper, consist of a $600 million, five-year revolver, expiring
      September 2010, available to Nicor and Nicor Gas, and a $400 million, 210-day
      seasonal revolver, which expired April 2006 and was available to Nicor Gas.
      The
      company had no commercial paper borrowings outstanding at June 30, 2006 and
      2005, and $490 million of commercial paper borrowings outstanding at December
      31, 2005. As mid to late-year seasonal purchases of natural gas are made to
      replenish gas in storage, the company intends to rely on existing





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and/or
      replacement credit agreements, which the company expects to establish during
      the
      second half of 2006. The company believes it is in compliance with all debt
      covenants at June 30, 2006 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.** In
      the
      second quarter of 2006, Nicor Gas signed an agreement to purchase approximately
      16 Bcf of synthetic natural gas annually for a 20-year term beginning as early
      as 2010. The agreement is contingent upon various milestones to be achieved
      by
      the counterparty to the agreement, including the construction of the facility
      which will produce the synthetic natural gas. Based on the significance of
      these
      milestones 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.





**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.





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











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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 June 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.





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
      interveners 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,








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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 June 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 has 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.* 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.





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**NEW
      ACCOUNTING PRONOUNCEMENT**





In
      July
      2006, the Financial Accounting Standards Board issued Interpretation No. 48, *Accounting
      for Uncertainty in Income Taxes* .
      This
      pronouncement has not yet been adopted by the company as of June 30, 2006 and
      is
      currently under review by the company. For more information, see Item 1 - Notes
      to the Condensed Consolidated Financial Statements - Note 3 - New Accounting
      Pronouncement.





**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.





Other
      factors that could cause materially different results include, but are not
      limited to, weather conditions; natural disasters; natural gas prices; 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











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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.





In
      the
      most recent quarter, the company completed the implementation of a new customer
      care and billing system. Other than this implementation, 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.





**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.





**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, 2006.3.02
            *
            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.)12.01
            
            Computation
                of Consolidated Ratio of Earnings to Fixed Charges.31.01
            
            Rule
                13a-14(a)/15d-14(a) Certification.31.02
            
            Rule
                13a-14(a)/15d-14(a) Certification.32.01
            
            Section
                1350 Certification.32.02
            
            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 descriptionof
              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 CompanyAugust
                2, 2006
            
            /s/
                KAREN K. PEPPING(Date)
            
            Karen
                K. PeppingVice
                President and Controller(Principal
                Accounting Officer andDuly
                Authorized Officer)



































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