UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-K

For the fiscal year ended December 31, 2002

or

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act: None

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 o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is an accelerated filer (as defined in rule 12b-2 of the Act).

Yes x  No o.

The aggregate market value of common stock (based on the June 28, 2002 closing price of $45.75) held by non-affiliates of the registrant was approximately $2.0 billion.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the company’s 2003 Annual Meeting Definitive Proxy Statement, dated March 31, 2003, are incorporated by reference into Part III.

Table of Contents

Item No.

Glossary

i

PART I

Item 1. Business

Nicor Inc. (Nicor), incorporated in 1976, is a holding company. Its principal subsidiaries are Northern Illinois Gas Company (doing business as Nicor Gas Company), one of the nation’s largest distributors of natural gas, and Tropical Shipping, a leading transporter of containerized freight in the Caribbean. Gas distribution is Nicor’s primary business, typically representing the majority of consolidated operating income and assets. Nicor also owns several unregulated energy-related ventures, including Nicor Services, a retail energy-related products and services business, and Nicor Enerchange, a wholesale natural gas marketing company. Nicor had approximately 3,500 employees at year-end 2002.

Financial information on Nicor’s major business segments is included in Business Segment and Geographic Information beginning on page 48. Certain terms used herein are defined in the glossary on page i.

GAS DISTRIBUTION

General

Nicor Gas, a regulated natural gas distribution utility, serves 2 million customers, in a service territory that encompasses most of the northern third of Illinois, excluding the city of Chicago. The company’s service territory is diverse and has grown steadily over the years, providing the company with a well-balanced mix of residential, commercial and industrial customers. In 2002, residential customers accounted for approximately 45 percent of natural gas deliveries, while commercial and industrial customers accounted for about 25 percent and 30 percent, respectively. Nicor Gas’ large residential customer base provides relative stability during weak economic periods. In addition, the company’s industrial and commercial customer base is well diversified, lessening the impact of industry-specific economic swings. See Gas Distribution Statistics on page 14 for operating revenues, deliveries and number of customers by customer classification. The company has approximately 2,300 employees.

Natural gas deliveries are seasonal since about one-half are used for space heating. Typically, about 70 percent of deliveries and revenues occur from October through March. Fluctuations in weather have the potential to significantly impact year-to-year comparisons of operating income and cash flow. Since 2000, Nicor Gas has purchased earnings protection against the impact of significantly warmer weather. To partially offset the cost of this protection, beginning in 2002 Nicor Gas agreed to pay its counterparty if weather was colder than an approximate normal. Thus far for 2003, weather protection has been purchased for only the first quarter and the agreement stipulates that the maximum payment received or amount paid out will not exceed $5 million.

Nicor Gas maintains franchise agreements with most of the communities it serves, allowing it to construct, operate and maintain distribution facilities in those communities. Franchise agreement terms range up to 50 years. Currently, less than 10 percent of the agreements will expire within five years.

As described in Management’s Discussion and Analysis — Customer Choice of Commodity Supplier on page 20, all Nicor Gas customers now have the option of purchasing their own gas supplies for delivery by Nicor Gas. Large transportation customers also have options that include the use of Nicor Gas’ storage system and the ability to choose varying supply backup levels. While Nicor Gas receives less revenue for transportation service as compared to gas sales service, the company receives a margin generally comparable to gas sales service for transportation service with full supply backup.

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Item 1. Business (continued)

Nicor Gas also has several nontraditional activities, including the Chicago Hub, which provides natural gas storage and transmission-related services to marketers, other gas distribution companies and electric power-generation facilities.

Sources of Natural Gas Supply

Nicor Gas purchases natural gas supplies in the open market by contracting directly with producers and marketers. Pipeline transportation and purchased storage services are regulated by the Federal Energy Regulatory Commission (FERC). Firm pipeline capacity and purchased storage services held by the company that are temporarily not needed can be released in the secondary market under FERC-mandated capacity release provisions, with proceeds reducing the company’s cost of gas charged to customers.

The company’s peak-day requirements are met through utilization of company-owned storage facilities, firm pipeline capacity, purchased storage services and other supply sources, arranged by either Nicor Gas or its customers. Nicor Gas has been able to obtain sufficient supplies of natural gas to meet customer requirements. The company believes natural gas supply availability will be sufficient to meet market demands in the foreseeable future.

Natural gas supply. Nicor Gas maintains a diversified portfolio of natural gas supply contracts. Firm supply contracts are diversified by supplier, producing region, quantity and available transportation. Contract pricing is generally tied to published price indices so as to approximate current market prices. The contracts also generally provide for the payment of fixed demand charges to ensure the availability of supplies on any given day and are typically negotiated annually.

The company also purchases gas supplies on the spot market to fulfill its supply requirements or to take advantage of favorable short-term pricing. Spot gas purchases accounted for about one-half of the company’s total gas purchases in the last three years.

As noted previously, customers served under the company’s transportation service tariffs purchase their own gas supplies. About one-half of the gas that the company delivered in 2002 was purchased by transportation customers directly from producers and marketers rather than from the company.

Pipeline transportation. Nicor Gas is directly connected to eight interstate pipelines, providing access to most of the major natural gas producing regions in North America. The company’s primary firm transportation contracts are with: Natural Gas Pipeline Company of America, Northern Natural Gas Company, Tennessee Gas Pipeline Company, Midwestern Gas Transmission Company and ANR Pipeline. All of the capacity covered by these contracts will expire by 2004. In the first quarter of 2003, Nicor Gas renewed several of these contracts beyond 2004.

Storage. Nicor Gas owns and operates seven underground natural gas storage facilities. This storage system is one of the largest in the gas distribution industry. With about 140 Bcf of top storage capacity, the system is designed to meet about 55 percent of the company’s estimated peak-day deliveries and approximately 30 percent of its normal winter deliveries. In addition to company-owned facilities, Nicor Gas purchases about 40 Bcf of storage services. Storage provides supply flexibility and improves the reliability of deliveries.

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Item 1. Business (continued)

Competition/Demand

Nicor Gas is one of the largest utility energy suppliers in Illinois, delivering about one-third of all utility energy consumed in the state. Substantially all single-family homes in Nicor Gas’ service territory are heated with natural gas. The company’s natural gas services compete with other forms of energy, such as electricity and oil, based on such factors as price, service, reliability and environmental impact. Significant factors that impact demand for natural gas include weather, economic conditions and price. While natural gas prices fluctuated greatly over the last several years, Nicor Gas has traditionally maintained a pricing advantage over electricity and expects to maintain an advantage in the foreseeable future.

Additional information on competition and demand is presented in Management’s Discussion and Analysis — Factors Affecting Business Performance beginning on page 18.

Regulation

Nicor Gas is regulated by the Illinois Commerce Commission (ICC), which establishes the rules and regulations governing utility rates and services in Illinois. Rates are generally designed to allow the company to recover its costs and provide an opportunity to earn a fair return for its investors. Significant changes in the regulations applicable to Nicor Gas or its affiliates, or the regulatory environment in general, could affect the performance of Nicor Gas.

The cost of gas the company purchases for customers is recovered through a monthly gas supply charge, which accounted for approximately 75 percent of a typical residential customer’s annual bill in the last three years. The company’s cost of gas is passed on to the customer without markup.

Nicor Gas’ performance-based rate (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. Additional information on the plan is presented in Management’s Discussion and Analysis — Performance-Based Rate Plan beginning on page 25.

The company’s Customer Select program® offers customers a choice of natural gas suppliers. Additional information on the program is presented in Management’s Discussion and Analysis — Customer Choice of Commodity Supplier on page 20.

Properties

The gas distribution, transmission and storage system includes approximately 31,000 miles of steel, plastic and cast iron main; approximately 28,000 miles of steel, plastic/aluminum composite, plastic and copper service pipe connecting the mains to customers’ premises; and seven underground storage fields. Other properties include buildings, land, motor vehicles, meters, regulators, compressors, construction equipment, tools, communication and computer equipment, software, and office equipment.

Most of the company’s distribution and transmission property, and underground storage fields are located on property owned by others and used by the company through easements, permits or licenses. The company owns most of the buildings housing its administrative offices and the land on which they sit.

Substantially all gas distribution properties are subject to the lien of the indenture securing Nicor Gas’ first mortgage bonds.

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Item 1. Business (continued)

Additional information about Nicor Gas’ business is presented in Management’s Discussion and Analysis — Gas Distribution beginning on page 19.

SHIPPING

Tropical Shipping is one of the largest containerized cargo carriers in the Caribbean, a region characterized by modest market growth and intense competition. Tropical Shipping’s financial results can be significantly affected by general economic conditions in the United States, the Caribbean region and Canada. The company is a major carrier of exports from the east coast of the United States and Canada to the Caribbean region. The company’s shipments consist primarily of southbound cargo such as building materials, food and other necessities for developers, manufacturers and residents in the Caribbean, as well as tourist-related shipments intended for use in hotels and resorts, and on cruise ships. The balance of Tropical Shipping’s cargo consists of northbound shipments of apparel and agricultural products, and interisland shipments. The company also provides additional related services including inland transportation and cargo insurance.

At December 31, 2002, Tropical Shipping’s fleet consisted of 11 owned vessels and 5 chartered vessels with a container capacity totaling approximately 5,200 TEUs. In 1999, Tropical Shipping ordered the construction of two vessels to replace older owned and chartered vessels, and to support growth. The first vessel was placed into service in late 2001, and the second vessel was delivered in early 2002. During the first quarter of 2003, Tropical Shipping sold one of its older vessels. In addition, the company owns containers, container-handling equipment, chassis and other equipment. Real property, more than half of which is leased, includes office buildings, cargo handling facilities and warehouses located in the United States, Canada, and some of the ports served.

Additional information about Tropical Shipping’s business is presented in Management’s Discussion and Analysis — Shipping on page 21.

OTHER ENERGY VENTURES

Nicor is involved in several other energy venture businesses including Nicor Services, Nicor Enerchange, Nicor Energy and Horizon Pipeline.

Nicor Services provides energy-related products and services for retail markets, including residential and small commercial users. The company offers products and services covering the installation, maintenance and repair of heating and air conditioning related equipment, including natural gas piping inside homes and other appliances. In 2002, the company also began offering a fixed bill product under which it pays the annual gas service portion of a Nicor Gas customer’s utility bill in exchange for twelve equal monthly payments by the customer to Nicor Services, regardless of changes in the price of natural gas or weather.

Nicor Enerchange is a natural gas marketing company formed in 1998 to engage in wholesale marketing and trading of natural gas supply services primarily in the Midwest. Nicor Enerchange also administers the Nicor Gas Chicago Hub for a fee. The company focuses on opportunities that allow it to leverage its knowledge of natural gas movement in and around the Midwest.

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Item 1. Business (concluded)

Nicor is a 50-percent owner of Nicor Energy, a retail energy marketing joint venture with Dynegy Marketing and Trade. Nicor Energy is in the process of liquidating its assets. For factors affecting Nicor Energy see the Notes to the Consolidated Financial Statements — Contingencies — Nicor Energy beginning on page 54.

During the second quarter of 2002, Horizon Pipeline, a 50-percent-owned joint venture with Natural Gas Pipeline Company of America, put into operation a 74-mile, 36-inch pipeline from Joliet, Illinois to near the Wisconsin/Illinois border. Horizon Pipeline’s capacity is nearly fully subscribed under 10-year agreements at rates that have been accepted by FERC, with Nicor Gas having contracted for approximately 80 percent of the 380 MMcf per day initial capacity.

ENVIRONMENTAL MATTERS

For information on environmental matters, see Management’s Discussion and Analysis — Contingencies beginning on page 25 and the Notes to the Consolidated Financial Statements — Contingencies beginning on page 53.

AVAILABLE INFORMATION

Nicor files various reports with the Securities and Exchange Commission (SEC). The reports include the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13 (a) of the Securities Exchange Act of 1934. Nicor makes all of these reports available without charge to the public on its web site at www.nicor.com as soon as reasonably practicable after Nicor files them with, or furnishes them to, the SEC.

Item 2. Properties

Information concerning Nicor and its major subsidiaries’ properties is included in Item 1, Business, beginning on page 1, and is incorporated herein by reference. These properties are suitable, adequate and utilized in the company’s operations.

Item 3. Legal Proceedings

See Management’s Discussion and Analysis — Contingencies beginning on page 25 and the Notes to the Consolidated Financial Statements — Contingencies beginning on page 53, which are incorporated herein by reference.

Item 4. Submission of Matters to a Vote of Security Holders

None.

5

Executive Officers of the Registrant

Executive officers of the company are elected annually by the Board of Directors.

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Executive Officers of the Registrant (concluded)

PART II

Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters

Nicor common stock is listed on the New York and Chicago Stock Exchanges. At February 28, 2003, there were approximately 26,000 common stockholders of record.

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Item 6. Selected Financial Data

(in millions, except per share data)

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The purpose of this financial review is to explain changes in operating results and financial condition from 2000 to 2002 and to discuss business trends and uncertainties that might affect Nicor Inc. (Nicor). Certain terms used herein are defined in the glossary on page i.

SUMMARY

Nicor’s two major subsidiaries, Nicor Gas and Tropical Shipping, operate in two business segments — gas distribution and shipping. All of Nicor’s other wholly owned businesses are combined and presented as “Other Energy Ventures.” The gas distribution segment represents the majority of consolidated operating income and assets.

Net income and diluted earnings per common share are presented below:

Nicor’s net income and earnings per share were significantly impacted by the effects of Nicor Gas’ mercury inspection and repair program in 2002, 2001 and 2000. A charge of $148 million was recorded as operating expense in 2000 to establish a reserve related to the program. In 2002 and 2001, the recognition of partial recoveries from insurers and contractors and reserve reductions lowered operating expenses by $29.0 million and $12.2 million, respectively. For details of Nicor Gas’ mercury inspection and repair program, see the Notes to the Consolidated Financial Statements — Mercury Program beginning on page 57.

Net income was higher in 2002 compared with 2001 due primarily to increased insurance recoveries at the company’s gas distribution segment related to the mercury inspection and repair program, partially offset by other operating income reductions in the gas distribution segment. Lower net interest expense, and operating income improvements in the shipping segment, also contributed to the 2002 improvement.

Net income was significantly higher in 2001 compared with 2000 due primarily to the mercury-related charge recorded in 2000 and related cost recoveries and a reserve reduction recorded in 2001 in the gas distribution segment. This increase was partially offset by other gas distribution operating income reductions and lower operating results in the shipping segment. 2001 also reflects increased interest income from higher short-term investment balances and lower interest expense due to lower interest rates.

Per share results in both 2002 and 2001 benefited from the company’s common stock repurchase programs.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

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

The following summarizes operating income comparisons by business segment:

•		Gas distribution operating income increased $12.6 million in 2002. The improvement reflects $29.0 million of pretax mercury-related insurance recoveries and positive reserve adjustments in 2002 compared to $12.2 million in the prior year. Annual results were also impacted favorably by lower losses related to a performance-based rate (PBR) plan ($10.7 million), increased natural gas deliveries unrelated to weather ($6.6 million) and colder weather ($4.3 million). Results were negatively impacted by higher operating costs, including lower pension credits ($14.1 million), increased legal and accounting costs related primarily to the PBR plan review ($8.7 million), higher depreciation ($5.2 million) and higher health care costs ($5.0 million).
		Gas distribution operating income increased $138.7 million in 2001 compared to 2000 reflecting a $160.2 million change in mercury-related costs and recoveries, increased contributions from the Chicago Hub ($6.9 million), which provides gas supply-related services, and increased pension credits ($3.7 million). The above improvements were partially offset by the impact of greater losses from the PBR plan ($11.6 million), reduced natural gas deliveries ($8.2 million), certain increased operating expenses related to higher average natural gas prices ($6.1 million) and increased depreciation ($3.4 million).
•		Tropical Shipping operating income for 2002 increased $2.1 million compared to 2001 due to increased revenues from higher volumes shipped ($46.3 million) attributable primarily to recent acquisitions, partially offset by the impact of higher operating expenses ($33.6 million) and lower average rates ($10.9 million) due primarily to increased volumes shipped as a result of recent acquisitions and unfavorable economic conditions throughout the Caribbean region.
		A slowdown in the U.S. and Caribbean economies resulted in a decrease in shipping operating income of $7.1 million in 2001. The negative revenue impact of lower volumes shipped ($23.9 million) in 2001 more than offset the positive effects of slightly higher average rates ($8.2 million), due primarily to a change in product and route mix, and lower operating and maintenance expenses ($7.7 million).
•		Other energy ventures operating income for 2002 decreased $.4 million compared to 2001. Higher operating results in the company’s energy-related products and services business ($4.2 million), Nicor Services, were more than offset by increased losses from the company’s former energy system development activities ($4.7 million).

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Operating income from Nicor’s other energy ventures was essentially unchanged in 2001. Improved 2001 operating results from Nicor Services ($2.2 million) and increased operating income relating to the company’s former energy system development activities ($2.2 million) were more than offset by a decline in operating income from a small venture that had a large one-time project in 2000 ($4.6 million).

Equity investment income (loss). Equity investment income (loss) was $(5.8) million in 2002 compared to $.4 million in 2001 and $1.0 million in 2000. Lower results in 2002 reflect a $9.2 million investment loss from Nicor Energy, Nicor’s retail energy marketing joint venture, compared with a loss of $.9 million in 2001.

Other income (expense). Other income (expense), net was $3.4 million in 2002, $7.6 million in 2001, and $4.9 million in 2000. The fluctuation from year to year was due primarily to short-term investment levels and the resulting effect on interest income.

Interest expense. Interest expense decreased $7.5 million in 2002 due to lower average borrowing levels and interest rates. Interest expense decreased $2.4 million in 2001 due primarily to the positive effect of lower interest rates.

Income taxes. The 17 percent effective income tax rate for 2000 varied from its historical level due to much lower pretax income related to the mercury charge at Nicor Gas. Lower pretax income typically results in a lower effective income tax rate because tax credits and other permanent tax differences represent a larger share of pretax income.

RESULTS OF OPERATIONS

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

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

Gas distribution revenues decreased in 2002 due primarily to significantly lower average natural gas costs, which are passed directly through to customers without markup. The revenue effect of the lower average natural gas costs is estimated to be approximately $575 million. The revenue effect of the lower natural gas costs was partially offset by the impact of colder weather ($85.2 million) in 2002 compared to 2001. In 2002, shipping segment results included higher volume-related revenues ($46.3 million) partially offset by lower average rates ($10.9 million). The increases in volume-related revenues resulted primarily from acquisitions. The slow economy in the Caribbean region continued to put pressure on shipping segment average rates. The increase in revenues for other energy ventures was due primarily to increased business activity at Nicor Services. Nicor Services’ 2002 revenues increased $27.0 million in

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

2002 to $40.0 million. Partially offsetting this increase were decreased revenues from former energy system development activities ($10.1 million).

The increase in 2001 gas distribution revenues from 2000 was due primarily to significantly higher average natural gas costs and related revenue taxes. The revenue effect of the higher average natural gas costs in 2001 compared to 2000 is approximately $300 million. Partially offsetting the effect of higher average 2001 gas costs were the estimated effects of lower deliveries ($134 million) due to warmer weather, energy conservation and economic conditions. The decline in shipping revenues in 2001 reflects the effect of lower volumes ($23.9 million) compared to the prior year. Reduced volumes were due to a slowdown in the economy, which resulted in lower construction and tourist-related shipments in the Caribbean region. The increase in revenues for other energy ventures was due primarily to increased business from Nicor’s former energy system development activities ($13.4 million) and new customers and products at Nicor Services ($5.7 million). Partially offsetting these increases was the decline in activity at a small venture ($7.9 million) that had a large one-time project in 2000.

Gas distribution margin. Nicor utilizes a measure it refers to as “gas distribution margin” to evaluate the operating income impact of gas distribution revenues. Gas distribution revenues include gas costs, which are passed directly through to customers without markup, and revenue taxes, for which Nicor Gas earns only a small administrative fee. These items often cause significant fluctuations in gas distribution revenues, and yet they have virtually no direct impact on gas distribution operating income. Therefore, Nicor Gas and many other gas utility companies exclude these items in evaluating performance. A reconciliation of gas distribution revenues and margin follows (in millions):

Gas distribution margin increased $23.9 million in 2002. Contributing to the 2002 improvement were lower PBR plan losses compared to 2001 ($10.7 million). Additional information related to the PBR plan is included in the Notes to the Consolidated Financial Statements — Contingencies — Performance-Based Rate Plan beginning on page 53. Other factors affecting margin in 2002 were the positive effects of increased natural gas deliveries unrelated to weather ($6.6 million) and colder weather ($4.3 million), and the negative effect of lower revenues from customer finance charges ($4.8 million). The reduction of revenues from customer finance charges is related to lower levels of customer receivables arising from reduced natural gas prices in 2002.

Gas distribution margin in 2001 was $6.0 million lower than in 2000. Positively affecting the 2001 margin were greater customer finance charges ($7.1 million) and larger contributions from the Chicago Hub ($6.9 million). Lower customer demand ($12.4 million) and increased PBR plan losses ($11.6 million) negatively impacted results in 2001. Reduced customer demand for natural gas in 2001 resulted from warmer weather, energy conservation and economic conditions. The negative impact of warmer weather in 2001 versus 2000 ($5.1 million) was partially offset by benefits from the company’s weather protection ($4.2 million).

Gas distribution operating and maintenance expense. Gas distribution operating and maintenance expense for 2002 and 2001 was $199.6 million and $177.1 million, respectively. The $22.5 million increase reflects smaller pension credits ($14.1 million), increased legal and accounting costs related

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

primarily to the PBR plan review ($8.7 million) and increased health care costs ($5.0 million). These increases were partially offset by lower natural gas costs to operate company equipment and facilities ($4.2 million).

Gas distribution operating and maintenance expense was $177.1 million in 2001, up $10.7 million from 2000. The increase in 2001 was due largely to increased bad debt expense ($6.7 million) and higher natural gas costs to operate company equipment and facilities ($4.8 million) resulting from higher natural gas prices. Partially offsetting these increases were higher pension credits ($3.7 million) in 2001 compared to 2000.

Gas distribution operating and maintenance expense included pension credits of $9.2 million, $23.3 million and $19.6 million in 2002, 2001 and 2000, respectively. For more details concerning fluctuations in the gas distribution’s pension credits, see the Factors Affecting Business Performance — Gas Distribution — Pension Investment Returns section on page 20.

Gas distribution mercury-related costs (recoveries). Mercury-related costs (recoveries) reflect the estimated costs, credits and recoveries associated with the company’s mercury inspection and repair program. In 2002, Nicor Gas reached an agreement with an insurer whereby the company recovered approximately $20 million of mercury-related costs. In both 2002 and 2001, a $9 million adjustment lowered the mercury-related reserve and reduced operating expense. Operating income for 2001 also reflected $3.2 million in mercury-related recoveries. The $148 million of mercury-related costs in 2000 represents the original charge to establish the mercury program reserve. Additional information about the company’s mercury inspection and repair program is presented in the Notes to the Consolidated Financial Statements - Contingencies — Mercury Program beginning on page 57.

Gas distribution property sale (gains) losses. Property sale gains and losses vary from year-to-year depending upon property sales activity. The company continues to assess its ownership of real estate holdings.

Shipping operating expenses. Shipping segment operating expenses rose $33.6 million in 2002 due primarily to increased volumes shipped as a result of recent acquisitions. Increased costs included higher transportation and voyage costs ($10.6 million), greater leased equipment costs ($5.1 million), higher wage and benefit costs ($4.1 million) and increased vessel charter expenses ($2.6 million).

For 2001, shipping segment operating expenses decreased $10.9 million due primarily to lower volumes shipped. Decreased volume-related expenses included lower port costs ($3.7 million), lower fuel costs ($1.9 million) and decreased wage and benefit expenses ($2.1 million).

All other operating expenses. The $2.9 million increase in all other operating expenses was due primarily to increased expenses at Nicor Services ($22.8 million) associated largely with the addition of new customers and products, such as the fixed bill product described in the following Factors Affecting Business Performance section. The 2002 increase at Nicor Services included $13.9 million of fixed bill operating expenses that were eliminated against gas distribution revenues in Nicor’s consolidated financial statements. The increase at Nicor Services was partially offset by lower operating expenses from Nicor’s former energy system development activities ($5.4 million) and its gas distribution technology business ($4.3 million).

The increase in all other operating expenses in 2001 compared to 2000 was associated largely with increased business from Nicor’s former energy system development activities ($11.2 million).

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Gas Distribution Statistics

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Shipping Statistics

FINANCIAL CONDITION AND LIQUIDITY

The company believes it has access to adequate resources to meet its needs for capital expenditures, debt redemptions, dividend payments and working capital. These resources include net cash flow from operating activities, access to capital markets, lines of credit and short-term investments.

Operating cash flows. Net cash flow provided from operating activities was $268.3 million, $491.3 million and $233.0 million in 2002, 2001 and 2000, respectively. Year-to-year changes in operating cash flow result largely from fluctuations in working capital items occurring mainly in the gas distribution segment because of factors including weather, the price of natural gas, the timing of collections from customers and gas purchasing practices. Operating cash flows increased significantly in 2001 due primarily to changes in amounts due from customers and accounts payable balances associated with natural gas price volatility. The company generally relies on short-term financing to meet temporary increases in working capital needs.

Capital expenditures. Capital expenditures by business segment are presented below (in millions):

The increase in 2002 capital expenditures in the gas distribution segment was related to the acquisition of a compressor for a storage facility and higher capitalized employee benefit costs. Gas distribution capital expenditures were higher in 2001 than in 2000 due primarily to increased information technology projects and improvements to the company’s operating system.

Shipping segment capital expenditures were higher in 2001 and 2000 than the 2002 and anticipated 2003 levels due primarily to the construction of two vessels. Expenditures were lower in 2002 and are expected to be further reduced in 2003 because vessel construction was completed in early 2002.

Other investments. Nicor invested $10 million in each of 2002, 2001 and 2000 in a cargo container leasing business and will likely invest a similar amount in 2003. Nicor’s equity investment in this business at December 31, 2002 was $70.3 million.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

In May 2002 Nicor invested $16.5 million for a 50-percent share of equity in Horizon Pipeline. Nicor’s equity investment in this business at December 31, 2002 was $18.4 million. Additional information about Horizon Pipeline is presented on page 22.

Nicor’s equity investment in Nicor Energy, including an $8.3 million note receivable, was written down to zero during the third quarter of 2002. Additional information about transactions with Nicor Energy is provided within the Nicor Energy section of the Notes to the Consolidated Financial Statements - Contingencies beginning on page 54.

In both 2002 and 2001, Nicor Services acquired a heating, ventilation and air conditioning (HVAC) company. In March 2003, Nicor Services acquired a third HVAC company. All purchases were made with shares of Nicor stock. Nicor Services has no current plans for further HVAC acquisitions.

In October 2001, Tropical Shipping acquired the container assets of Kent Line International for cash. With this acquisition, Tropical Shipping began offering Canadian customers an all-water service from New Brunswick, Canada, to Tropical Shipping’s network of Caribbean destinations and Florida. In April 2002, Tropical Shipping also purchased certain assets of Tecmarine Lines Inc. and TMX Logistics Inc. for cash, expanding its network of Caribbean and South American destinations.

Financing activities. As of the filing date of this report, Nicor Gas has long-term debt ratings that are among the highest in the gas distribution industry. Because of uncertainties pertaining to the energy industry in general and to the company, as described in the Notes to the Consolidated Financial Statements — Contingencies beginning on page 53, the rating agencies put Nicor and Nicor Gas’ long-term debt ratings under review for possible downgrade or on credit watch with negative implications in 2002. Moody’s Investors Service and Fitch Ratings have also put both companies’ commercial paper on credit watch. On November 5, 2002, Fitch Ratings lowered its rating on Nicor Gas’ long-term debt to AA from AA+ and lowered its rating on Nicor Inc.’s short-term debt to F1 from F1+. Nicor Gas’ F1+ short-term debt rating was unchanged. Lower ratings could cause higher interest costs. Nicor’s financial statistics at December 31 include:

Interest coverage for 2000 was negatively affected by the unusual mercury-related charge.

Long-term debt. Nicor is in compliance with its debt covenants and believes it will remain so even if its debt ratings are lowered. Nicor’s long-term debt agreements do not include ratings triggers or material adverse change provisions. Net proceeds from securities issued are typically used for refinancing outstanding debt, construction programs to the extent not provided by internally generated funds, and general corporate purposes.

In April 2002, Nicor Gas issued $50 million of 3 percent unsecured notes due in April 2003 with the proceeds to be used for general corporate purposes. Nicor Gas plans to refinance at least $100 million of long-term debt in 2003.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

In 2001, Nicor Gas issued the following First Mortgage Bonds: $50 million due in 2006 at 5.55%, $75 million due in 2008 at 5.875%, $75 million due in 2011 at 6.625%, and $50 million due in 2016 at 7.2%. Retirements of First Mortgage Bonds in 2001 were as follows: $75 million due in 2001 at 6.45%, $50 million due in 2002 at 6.75%, $50 million due in 2021 at 8.875%, and $50 million due in 2025 at 7.26%. During 2001, Nicor Gas also retired $50 million of variable-rate unsecured notes. As a result of these activities, Nicor’s weighted average interest rate for long-term debt at December 31, 2001 was 6.3% compared with 6.8% at December 31, 2000.

In January 2000, Nicor Gas issued $50 million of variable-rate unsecured notes due in 2001 at an initial rate of 6.11% to fund the redemption of $50 million of unsecured notes at 5.065% due in 2000.

Short-term debt. At December 31, 2002, the company had line of credit agreements with five major domestic and foreign banks. These agreements, which serve as backup for the issuance of commercial paper, allow for borrowings of up to $409 million through March 31, 2003 and $334 million thereafter through September 30, 2003. At December 31, 2002 the company had $315 million of commercial paper borrowings outstanding. Nicor had $277 million of commercial paper outstanding at year-end 2001. Under the company’s 2002/2003 short-term line of credit agreements, if Nicor’s ratio of consolidated total indebtedness to capitalization (including short-term debt) exceeds 65% during the term of the credit facility while there are short-term bank loans outstanding, each bank may at its option declare any amounts due immediately payable and/or terminate its commitment to make advances to the company. The company expects that commercial paper funding will continue to be available in the foreseeable future.

Common stock. In 2001, Nicor completed a $50 million common stock repurchase program initiated in the third quarter of 2000 and announced a new $50 million common stock repurchase program. Purchases may be made as market conditions permit through open market transactions and to the extent cash flow is available after other cash needs and investment opportunities. The company purchased and retired .4 million, 1.1 million and 1.4 million common shares in 2002, 2001 and 2000, respectively, at a cost of $18 million, $42 million and $50 million, respectively, under the stock repurchase program. At December 31, 2002, approximately $22 million remained authorized for the repurchase of common stock under the existing program. Since January 1990, the company has repurchased over one-quarter of its outstanding stock.

Nicor increased its quarterly common stock dividend rate during 2002 by 4.5 percent, which was the fifteenth consecutive annual increase. On March 20, 2003, the Nicor Board of Directors declared a quarterly dividend of $.465 per common share, increasing the rate by 1.1%. The company paid dividends on its common stock of $80.4 million, $78.5 million and $75.7 million in 2002, 2001 and 2000, respectively. Nicor currently has no contractual or regulatory restrictions on the payment of dividends.

Commitments. For a summary of Nicor’s contractual obligations, refer to the Notes to the Consolidated Financial Statements — Contractual Obligations beginning on page 51. In addition to its contractual obligations, Nicor could be required to provide funding on behalf of related parties under guarantee arrangements if certain contingent events occur. These guarantees are described in the Notes to the Consolidated Financial Statements — Related Party Transactions on page 51, the Notes to the Consolidated Financial Statements - Guarantees and Indemnities on page 52 and the Notes to the Consolidated Financial Statements — Contingencies — Nicor Energy beginning on page 54.

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

17

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

FACTORS AFFECTING BUSINESS PERFORMANCE

The following factors can impact year-to-year comparisons and may affect the future performance of Nicor’s businesses.

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

The selection of accounting methods and the use of estimates affect Nicor’s reported results and financial condition. The company has adopted several significant accounting policies that are important to understanding its financial statements and are described in the Notes to the Consolidated Financial Statements — Accounting Policies beginning on page 37. Management is also required to make significant estimates, which are similarly described in the footnotes.

Although there are numerous areas in which Nicor management makes significant estimates or judgments, it believes its critical estimates or judgments involve derivative instruments, unbilled revenues, credit risk and loss contingencies because they are susceptible to material change and could materially impact Nicor’s financial statements.

The rules for determining whether a contract meets the criteria for a derivative instrument, or whether a derivative qualifies for hedge accounting treatment, are numerous and complex. The treatment of a single contract may vary from period to period depending upon accounting elections and changes in management’s assessment of the likelihood of future hedged transactions. As a result, management judgment is required in the determination of the appropriate accounting treatment. In addition, the estimated fair value of derivative instruments may change significantly from period to period depending upon market projections, and changes in hedge effectiveness may impact the accounting treatment. These determinations and changes in estimates may have a material impact on reported results.

Certain Nicor subsidiaries estimate revenues for gas deliveries not billed to customers from the last billing date to month-end (unbilled revenues). Unbilled revenue estimates are dependent upon a number of factors which require management judgment, including projections of gas costs, weather, and customer usage. These estimates are adjusted when actual billings occur, and changes in estimates can be material. Nicor’s estimated unbilled revenues at December 31, 2002, were $142.9 million.

Nicor’s subsidiaries and affiliates are required to estimate credit risk in establishing allowances for doubtful accounts and in estimating the fair values of certain derivative instruments and energy-related trading contracts, with counterparty credit risk being an especially difficult and critical judgment. Actual credit losses could vary materially from Nicor’s estimates. Nicor’s estimated allowance for doubtful accounts at December 31, 2002, was $16.9 million.

Nicor records loss contingencies as liabilities when it is probable that a liability has been incurred and the amount of loss is reasonably estimable. Nicor and its subsidiaries and affiliates are involved in various legal proceedings and exposed to various loss contingencies (see discussion in Contingencies beginning on page 25 and the Notes to the Consolidated Financial Statements — Contingencies, beginning on page 53). These loss contingencies are in some cases resolved in stages over time, estimates may change significantly from period to period, and the company’s ultimate obligations may differ materially from its estimates. Of particular note is the PBR plan contingency described in Contingencies — Performance-

18

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Based Rate Plan beginning on page 25 and in the Notes to the Consolidated Financial Statements — Contingencies — Performance-Based Rate Plan beginning on page 53.

Gas distribution. Nicor Gas, a regulated natural gas distribution utility, serves two million customers in a service territory that encompasses most of the northern third of Illinois, excluding the city of Chicago. The region’s economy is diverse and has grown steadily over the years, providing Nicor Gas with a well-balanced mix of residential, commercial and industrial customers. In 2002, residential, commercial and industrial customers accounted for approximately 45 percent, 25 percent and 30 percent of natural gas deliveries, respectively.

Weather. Since about one-half of gas deliveries are used for space heating, fluctuations in weather have the potential to significantly impact year-to-year comparisons of operating income and cash flow. Nicor estimates that, excluding weather protection, every 100-degree-day variation in weather has an impact on earnings per share of approximately 2-1/2 cents. Since 2000, Nicor Gas has purchased earnings protection against the impact of significantly warmer weather. To partially offset the cost of this protection, beginning in 2002 Nicor Gas agreed to pay its counterparty if weather is colder than an approximate normal. Thus far for 2003, weather protection has been purchased for only the first quarter and the agreement stipulates that the maximum payment received or amount paid out will not exceed $5 million.

Demand and natural gas prices. In addition to the impact of weather, significant changes in economic conditions or natural gas prices can impact customer gas usage. However, Nicor Gas’ large residential customer base provides relative stability during weak economic periods, and the industrial and commercial customer base is well diversified, lessening the impact of industry-specific economic swings. Nicor Gas’ growth in natural gas deliveries has traditionally come from customer additions and increased usage by existing commercial and industrial customers, including power-generation facilities. Although commercial and industrial deliveries declined in 2001, they increased in 2002 and the company anticipates continued long-term growth attributable to these factors. A partial offset is expected as customers install more energy-efficient equipment.

Changes in the price of natural gas have no direct impact on Nicor Gas’ margin since gas costs are passed directly through to customers without markup. However, high natural gas prices can have an adverse effect on accounts receivable collections, customer demand, company-use gas expenses, financing costs and customer service expenses.

Competition. Nicor Gas competes with other energy suppliers based on such factors as price, service and reliability. The company believes that it is well positioned to deal with the possibility of fuel switching by customers because it has rates and services designed to compete against alternative fuels. In addition, the company has a rate that allows negotiation with potential bypass customers, and no customer has bypassed the Nicor Gas system since the rate became effective in 1987. Nicor Gas also offers commercial and industrial customers alternatives in rates and service, increasing its ability to compete in these markets.

Storage and supply. Nicor Gas has a direct connection to multiple interstate pipelines and extensive underground storage capacity that provides the company and its transportation customers with flexibility and alternatives for natural gas supply procurement and storage services. In addition, in an effort to ensure supply reliability, the company purchases gas from several different producing regions under varied contract terms.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Customer choice of commodity supplier. The company’s Customer Select® program offers customers a choice of natural gas suppliers. Nicor Gas made its Customer Select program available to all residential customers beginning in March 2002. Previously, supplier choice was available to only industrial customers and, under a Customer Select pilot program, all commercial customers and about 15 percent of residential customers. In the pilot program’s first four years, about one-third of eligible business customers and one-quarter of eligible residential customers signed up. The choice of another natural gas commodity supplier has no direct impact on Nicor Gas’ distribution margin because natural gas costs are passed directly through to customers without markup. Nicor Gas continues to deliver the natural gas, maintain its distribution system and respond to emergencies.

Customer credit risk. Nicor Gas has a diversified customer base, which limits its exposure to concentrations of credit risk in any one industry or income class. The company believes that it maintains prudent credit policies, subject to ICC regulations. Customers also have options to help them manage their bills, such as energy assistance programs for low-income customers and a budget payment plan that spreads gas bills more evenly throughout the year. However, high natural gas prices can increase the risk of customer nonpayment. Nicor Gas experienced increased bad debt expense in 2002, 2001 and 2000 that was higher than historical levels due primarily to significantly higher natural gas prices. It is expected that higher natural gas prices will continue in 2003. See also the Credit Risk section on page 23.

Pension investment returns. Nicor Gas maintains noncontributory defined benefit pension plans covering substantially all employees hired prior to 1998. Net income related to net periodic benefit credits represented 4 percent, 12 percent and 33 percent of Nicor’s net income in 2002, 2001, and 2000, respectively. The 2000 percentage was significantly affected by Nicor’s lower net income in 2000, which resulted from the unusual mercury program charge. For actuarial valuation purposes, Nicor Gas utilizes an October 1 measurement date to determine the company’s pension expense or credit for the subsequent calendar year. During the 12 months ended September 30, 2001, the pension plans experienced poor investment returns consistent with general market conditions, negatively impacting the company’s 2002 operating income. The company’s pension credit included in operating income in 2002 was $9.2 million compared to $23.3 million in 2001. The October 1, 2002 actuarial valuation reflected even lower asset values which, along with changes in actuarial assumptions, will lead to a materially lower pension credit for 2003, reducing operating income by about $9 million. Actuarial assumptions affecting 2003 include an expected rate of return on plan assets of 8.75 % and a discount rate of 6.75%. The pension plans are adequately funded, and recent market performance is not expected to impact participant benefits or future company contributions. However, further substantial declines in market performance or changes to actuarial assumptions could require future company contributions.

Nontraditional activities. Nicor Gas continues to pursue nontraditional activities, including the Chicago Hub, which provides natural gas transportation and storage services. The Chicago area is a major market hub for natural gas, and demand exists for storage-related and transmission-related services by marketers, other gas distribution companies and electric power-generation facilities. During 2002, 2001 and 2000, the Chicago Hub contributed to operating income $15.4 million, $13.0 million and $6.1 million, respectively.

20

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Regulation. Nicor Gas is regulated by the ICC, which establishes the rules and regulations governing utility rates and services in Illinois. Rates are generally designed to allow the company to recover its costs and provide an opportunity to earn a fair return for its investors. Significant changes in the regulations applicable to Nicor Gas or its affiliates, or the regulatory environment in general, could affect the performance of Nicor Gas. Information regarding certain ICC proceedings is presented within the Contingencies - Performance-Based Rate Plan section beginning on page 25 and within the Notes to the Consolidated Financial Statements — Contingencies — Performance-Based Rate Plan beginning on page 53. In addition, Nicor Gas provides certain FERC-regulated storage and transportation services, and information concerning FERC-regulated activities is discussed in the Contingencies — Hub Services section and in the Contingencies — Other FERC Matters section on page 28.

Outlook. Due to the absence of the positive mercury-related impacts that occurred in 2002 and an anticipated increase in pension, health care and insurance costs, lower gas distribution results are expected in 2003.

Shipping. Tropical Shipping is one of the largest containerized cargo carriers in the Caribbean region. Tropical Shipping has a reputation for providing quality, on-time delivery service — a reputation that has helped the company establish a leading position in most of the markets it serves. The company is a major carrier of exports from the east coast of the United States and Canada to the Caribbean region.

The company’s shipments consist primarily of southbound cargo such as building materials, food and other necessities for developers, manufacturers and residents in the Caribbean, as well as tourist-related shipments intended for use in hotels and resorts, and on cruise ships. The balance of Tropical Shipping’s cargo consists of northbound shipments of agricultural products and apparel, and interisland shipments.

Tropical Shipping’s financial results can be affected significantly by general economic conditions in the United States, the Caribbean region and Canada. The Caribbean marketplace is very competitive, with global carriers having established a presence in several markets that Tropical Shipping serves. Tropical Shipping is continuing to meet these challenges by focusing on superior customer service, controlling costs, and maximizing the efficiency and utilization of its vessel fleet and shore assets. In 1999, Tropical Shipping ordered the construction of two vessels to replace older owned and chartered vessels, and to support growth. The first vessel was placed into service in late 2001, and the second vessel was delivered in early 2002.

In October 2001, Tropical Shipping acquired the container assets of Kent Line International for cash. With this acquisition, Tropical Shipping began offering Canadian customers an all-water service from New Brunswick, Canada, to Tropical Shipping’s network of Caribbean destinations and Florida. The acquisition has the potential to increase Tropical Shipping’s annual volumes by about 10 percent.

In April 2002, Tropical Shipping also purchased certain assets of Tecmarine Lines Inc. and TMX Logistics Inc. for cash, expanding its network of Caribbean and South American destinations. The acquisition has the potential to increase Tropical Shipping’s annual volumes by approximately 10 percent.

Nicor anticipates modest growth in the shipping segment in 2003.

21

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Other energy ventures. Nicor is involved in several other energy venture businesses including Nicor Services, Nicor Enerchange, Nicor Energy and Horizon Pipeline.

Nicor Services provides energy-related products and services for retail markets, including residential and small commercial users. The company offers products and services covering the installation, maintenance and repair of heating and air conditioning related equipment, including gas piping and other appliances. In 2002, the company also began offering a fixed bill product under which it pays the annual gas service portion of a Nicor Gas customer’s utility bill in exchange for twelve equal monthly payments by the customer to Nicor Services, regardless of changes in the price of natural gas or weather. Nicor Services contributed $7.4 million in operating income in 2002, compared with $3.2 million in 2001 and $1.0 million in 2000.

Nicor Enerchange is a natural gas marketing company formed in 1998 to engage in wholesale marketing and trading of natural gas supply services primarily in the Midwest. Nicor Enerchange also administers the Nicor Gas Chicago Hub for a fee. The company focuses on opportunities that allow it to leverage its knowledge of natural gas movement in and around the Midwest. Changes in the availability of storage capacity may negatively impact the results of Nicor Enerchange. Nicor Enerchange contributed $3.2 million of operating income in 2002, compared with $3.2 million in 2001 and $2.9 million in 2000. Beginning in 2003, Nicor Enerchange results will be subject to an increased risk of potential volatility caused by the adoption of a new accounting method. See the Notes to the Consolidated Financial Statements — Energy Trading Accounting Methods on page 41.

Nicor is a 50-percent owner of Nicor Energy, a retail energy marketing joint venture with Dynegy Marketing and Trade. In 2002, Nicor recorded a pretax loss of $9.2 million associated with this investment. Nicor Energy is in the process of liquidating its assets. For factors affecting Nicor Energy see the Notes to the Consolidated Financial Statements — Contingencies — Nicor Energy beginning on page 54.

During the second quarter of 2002 Horizon Pipeline, a 50-percent-owned joint venture with Natural Gas Pipeline Company of America, put into operation a 74-mile, 36-inch pipeline from Joliet, Illinois to near the Wisconsin/Illinois border. Horizon Pipeline’s capacity is nearly fully subscribed under 10-year agreements, with Nicor Gas having contracted for approximately 80 percent of the 380 MMcf per day initial capacity. Horizon Pipeline contributed $1.3 million of pretax earnings in 2002.

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

Commodity price risk. With regard to commodity price risk, the company has established policies and procedures governing the management of such risks and the use of derivative commodity instruments to hedge its exposure to such risks. A risk management committee oversees compliance with such policies and procedures. The company utilizes various techniques to limit, measure and monitor market risk, including limits based on volume, dollar amounts, and duration, and in some cases value at risk (VaR). VaR is the potential loss for an instrument or portfolio from adverse changes in market factors, for a specified time period and at a specified confidence level. The company’s risk management committee has established exposure limits at such a level that material adverse economic results are not expected.

22

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

However, beginning in 2003, the accounting results for any one period are subject to potential volatility caused by the adoption of the new accounting model at Nicor Enerchange. The company’s commodity price risk policies and procedures continue to evolve with its businesses and are subject to ongoing review and modification.

In accordance with Securities and Exchange Commission (SEC) disclosure requirements, Nicor performs sensitivity analyses to assess the potential loss in earnings based upon a hypothetical 10 percent adverse change in market prices. Management does not believe that sensitivity analyses alone provide an accurate or reliable method for monitoring and controlling risks and therefore also relies on the experience and judgment of its management to revise strategies and adjust positions as deemed necessary. Losses in excess of the amounts determined in sensitivity analyses could occur if market prices exceed the 10 percent shift used for the analyses. Based on the company’s unhedged positions at December 31, 2002, a 10 percent decrease in natural gas prices would have decreased Nicor’s earnings at December 31, 2002 by about $.1 million, which is not materially different than in the prior year.

In addition, substantial increases in natural gas prices may indirectly impact Nicor Gas’ earnings by increasing the cost of gas used by the company, bad debt expense and other operating expenses. Higher natural gas prices may also lead to lower customer gas consumption and margin. The company is addressing certain of these risks with fixed-rate purchase agreements, futures contracts and swap agreements to reduce the financial impacts arising from natural gas price changes.

Nicor’s regulated utility, Nicor Gas, is generally not exposed to market risk caused by changes in commodity prices because of Illinois rate regulation allowing for the recovery of prudently incurred natural gas supply costs from customers. However, Nicor Gas’ PBR plan for natural gas costs created some exposure to commodity price risk. The company’s exposure to this market risk was partially mitigated because the PBR plan compared actual gas costs to a market-sensitive benchmark as opposed to a fixed benchmark. Nicor Gas terminated the PBR plan effective January 1, 2003.

Nicor’s other energy businesses are subject to natural gas commodity price risk, arising primarily from fixed-price purchase and sale agreements and natural gas inventories. Derivative commodity instruments such as futures, options, forwards and swaps may be used to hedge this risk. In addition, management believes it has taken appropriate steps to manage other risks of loss associated with the Nicor Services’ fixed bill product.

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

On December 2, 2001 Enron North America Corporation (Enron) filed a voluntary petition for relief under Chapter 11 of Title XI of the United States Bankruptcy Code in the United States Bankruptcy Court for the Southern District of New York. At the date of Enron’s bankruptcy filing, the net amount due to Enron from Nicor Gas was $2.8 million, and the net amount due to Enron from Nicor Enerchange was $.9 million. Nicor Gas and Nicor Enerchange have filed their appropriate proof of claims with the U.S. Bankruptcy Court. In February of 2003 Enron and Nicor Enerchange entered into a settlement and mutual release whereby Nicor Enerchange will pay to Enron an amount of $.9 million in full settlement and release of all amounts due Enron. The settlement agreement entered into between Enron and Nicor

23

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Enerchange was approved on February 11, 2003 by the U.S. Bankruptcy Court. Nicor Gas and Enron are currently in the process of negotiating a settlement of all amounts currently due Enron.

Energy trading activities. At December 31, 2002, Nicor Enerchange, Nicor’s wholesale natural gas marketing business, had contracts outstanding with the following fair values (in millions):

The above fair values exclude $24.9 million attributable to natural gas inventory, which is valued at quoted spot market prices. As noted in the Notes to the Consolidated Financial Statements — New Accounting Pronouncements - Energy Trading Revenues on page 41, the accounting method applied to this business will change in the first quarter of 2003. As a result, natural gas inventory will be recorded at the lower of cost or market rather than at fair value, and annual and interim results will be subject to potential volatility caused by the adoption of the new accounting method.

Interest rate risk. Nicor is exposed to changes in interest rates. The company manages its interest rate risk by issuing long-term fixed-rate debt with varying maturities, refinancing certain debt and periodically hedging the interest rate on anticipated borrowings. For further information about debt securities, interest rates and fair values, see the Financial Statements - Consolidated Statements of Capitalization on page 35 and the Notes to the Consolidated Financial Statements — Fair Value of Financial Instruments on page 42 and the Notes to the Consolidated Financial Statements — Short-Term and Long-Term Debt on page 42.

Nicor currently has financial derivatives designated as hedges of interest payments on an anticipated issuance of 30-year bonds in 2003. These instruments are accounted for as cash flow hedges with the gains and losses recorded in other comprehensive income. In the unlikely event that the anticipated transaction does not occur as forecasted, some or all of the amount in other comprehensive income may need to be reclassified to net income. At December 31, 2002, accumulated other comprehensive income included after-tax losses of $4.6 million associated with these hedges.

Other operating expenses. Health care costs have been rising and Nicor expects significant additional increases. Nicor is also experiencing, and expects to continue to experience, higher insurance costs due to a tightening insurance market and company loss experience. These cost increases, either collectively or individually, could materially reduce Nicor’s future results of operations.

Accounting policies. The Financial Accounting Standards Board (FASB) issued key accounting pronouncements in 2002. For further information about these pronouncements, see the Notes to the Consolidated Financial Statements — New Accounting Pronouncements beginning on page 40. In addition, effective January 1, 2003, Nicor Gas will use a straight-line method for interim depreciation, a method used by other companies in its industry. Previously, Nicor Gas allocated depreciation to interim periods based upon the level of weather-normalized gas deliveries each quarter.

24

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

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

Performance-based rate 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 Illinois Commerce Commission (ICC) review.

There are allegations that the company acted improperly in connection with the PBR plan, and the ICC is 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’s Office (CCSAO), the Staff of the ICC and CUB entered into a stipulation providing for additional discovery. The Illinois Attorney General’s Office has also intervened in this matter. In addition, the Illinois Attorney General’s Office issued Civil Investigation Demands (CIDs) to CUB and the ICC Staff. The CIDs ordered that CUB and the ICC Staff produce all documents relating to any claims that Nicor Gas may have presented, or caused to be presented, false information related to its PBR plan. The Securities and Exchange Commission (SEC) and the Office of the United States Attorney for the Northern District of Illinois are also reviewing the allegations that the company acted improperly in connection with the PBR plan. The company has committed to cooperate fully in the reviews of the PBR plan. Nicor Gas has responded to numerous data requests that have been propounded by the ICC Staff, CUB, CCSAO, the SEC, the Illinois Attorney General’s Office and the Office of the United States Attorney for the Northern District of Illinois.

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. To conduct the inquiry, the Special Committee retained Scott Lassar of the law firm of Sidley Austin Brown & Wood (Sidley), and Sidley hired the accounting firm of KPMG LLP. Mr. Lassar is the former United States Attorney for the Northern District of Illinois.

The Special Committee presented the report of its counsel (Report) to Nicor’s Board of Directors on October 28, 2002. The transmittal letter from the Special Committee to Nicor’s Board of Directors and Mr. Lassar’s Report were filed with the SEC on a Form 8-K on October 31, 2002. The findings of the Report include:

•		Certain transactions increased customer costs in the aggregate amount of approximately $15 million.
•		No improper Nicor affiliated-party transactions or improper hedging activities were identified.
•		Inadvertent accounting errors occurred, sometimes to the benefit of customers and sometimes to the benefit of Nicor Gas.
•		No criminal activity or fraud was identified.

25

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

In response, the Nicor Board of Directors directed the company’s management to:

•		make appropriate adjustments to account for, and fully address, the adverse consequences to ratepayers of the items noted in the Report,
•		undertake a financial statement re-audit of 1999 to 2001 and a review of the first two quarters of 2002,
•		amend any filings with the ICC, the SEC or other regulatory agencies, as necessary,
•		conduct a full audit of management fees paid by the company to third parties during 2000 and 2001,
•		conduct a detailed study of management bonus issues, and
•		conduct a detailed study of the adequacy of internal accounting and regulatory controls.

Nicor and Nicor Gas previously restated their 2001, 2000 and 1999 annual financial statements and their 2002 and 2001 interim results to reflect corrections. The audited restated financial statements were previously filed with the SEC. In addition, Nicor and Nicor Gas have recorded additional charges in the fourth quarter of 2002.

The items included in the Report are reflected in the financial statements as follows (amounts pretax):

•		The $15 million of transactions identified in the Report, as noted above. $11.2 million of these customer costs relate to transactions that required corrections to gas purchase costs or storage volumes from 1999 to 2001. The remaining $4.1 million of the $15.3 million identified in the Report was recorded by Nicor Gas as a PBR plan loss contingency liability in the fourth quarter of 2002. The largest correction related to a late 1999 wholesale title transfer of natural gas from Nicor Gas’ storage inventory which had increased customers’ gas costs by approximately $6.75 million. The corrections also related to physical transfers of natural gas between Nicor Gas’ storage fields that were not consistently accounted for under the PBR plan and the improper classification of 2001 weather insurance premiums as cost of gas rather than operating expense. These two items increased customers’ gas costs by a total of $4.45 million. The corrections to gas costs had no direct impact on pretax income because gas costs are passed directly through to customers without markup. However, the gas cost and benchmark corrections did impact PBR plan results, as discussed below, and the weather insurance correction increased 2001 operating and maintenance expense by $2 million.
•		Changes in the timing of certain sales and purchases of natural gas inventory between Nicor Gas and independent third parties during the period December 1999 to the present. Nicor Gas had previously recorded these transactions based upon when it held title to the natural gas, but there are additional criteria that were not applied in determining the accounting treatment, including those set forth in FASB Statement No. 49, Accounting for Product Financing Arrangements, and Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements. For example, the level of economic interest in or control over the asset must be considered, which changes the timing of recognizing gas purchases and inventory in some of the third-party storage arrangements. In addition, in some instances a portion of the purchase cost is now classified as interest cost. These corrections increased both inventory and accounts payable at December 31, 2001 and 2000. The corrections to gas costs had no direct impact on pretax income because gas costs are passed directly through to customers without markup. However, the gas cost and benchmark corrections did impact PBR plan results, as discussed below, and interest expense increased by $1.0 million and $.6 million in 2001 and 2000, respectively.

26

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

•

PBR plan results. Since the calendar-year PBR plan calculations consider the cost of gas charged to customers and volumes withdrawn from inventory, which are both restated, PBR plan results have also changed and were reduced by $23.8 million and $15.4 million in 2001 and 2000, respectively.

In addition to the corrections related to the Report, as a result of management and audit reviews, the company also increased 2001 gas costs for transactions which had previously been recorded in the first quarter of 2002. This reduced Nicor Gas’ 2001 PBR plan results by $5.8 million.

The adjustments noted above reduced Nicor’s 2001 and 2000 pretax gas distribution results by $32.6 million and $16.0 million, respectively. The impact of the items listed above resulted in a reduction to net income for 2001 and 2000 of $19.7 million and $9.7 million, respectively.

Because the PBR plan and historical utility gas costs are still under ICC review, it is possible that the final outcome could be materially different than the amounts noted above. 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. Certain parties in the PBR plan review proceeding have indicated disagreement with the findings in the Report or have indicated that they believe substantially greater adjustments or penalties are warranted. In addition, 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 refunds to consumers in an amount much greater than the $15 million of adjustments identified in the Report. On March 5, 2003, the ICC staff filed a response brief in support of CUB’s motion for sanctions. It is not possible to determine how the ICC will resolve the claims of CCSAO, CUB or other parties to the ICC Proceedings.

Nicor is unable to predict the outcome of any of the foregoing reviews or the company’s potential exposure thereunder beyond the amounts noted above. Also, due to the uncertainties surrounding the PBR plan, Nicor Gas has not recognized a $26.9 million pretax gain from the 2002 PBR plan year. In a letter dated October 28, 2002, Nicor Gas informed the ICC that it was terminating its PBR plan effective January 1, 2003.

On July 22, 2002, a purported class action was filed against Nicor Gas and Nicor in the Circuit Court of Cook County, Illinois, on behalf of all customers of Nicor Gas who at any time from January 2000 through the present were subject to Nicor Gas’ PBR plan. The named plaintiffs alleged breach of contract, unjust enrichment and violation of the Illinois Consumer Fraud and Deceptive Practices Act, and that the class sustained damages as a result of Nicor Gas manipulating the benchmark under the PBR plan. The named plaintiffs sought, on behalf of themselves and the purported class, compensatory damages, prejudgment and postjudgment interest, disgorgement of all profits, and restitution to plaintiffs and the purported class. Nicor filed a Motion to Dismiss this action on September 24, 2002. On December 4, 2002, the named plaintiffs voluntarily dismissed the case, but indicated an intent to bring their claims before the ICC. Nicor is unable to predict the outcome of any such proceeding or Nicor’s potential exposure related thereto and has not recorded a liability associated with the potential outcome of this contingency.

Nicor Energy. Significant developments have occurred relating to Nicor’s 50-percent interest in Nicor Energy. Information about these developments is presented within the Notes to the Consolidated Financial Statements — Contingencies — Nicor Energy beginning on page 54.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

SEC and U.S. Attorney Inquiries. In 2002, the staff of the SEC informed Nicor and Nicor Energy that the SEC is conducting a formal inquiry regarding the PBR plan and Nicor Energy. On January 28, 2003, Nicor Energy 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 Energy, alleging that it violated Sections 10(b) and 13(b)(5) of the Securities Exchange Act of 1934. A representative of the Office of the United States Attorney for the Northern District of Illinois has notified Nicor that that office is conducting an inquiry on the same matters that the SEC is investigating, and a grand jury is also reviewing these matters.

Securities Class Actions. Nicor and certain of its executives are defendants in a consolidated class action lawsuit. Information about this action is presented within the Notes to the Consolidated Financial Statements — Contingencies — Securities Class Actions on page 55.

Shareholder Derivative Lawsuits. Certain Nicor executives and all members of its Board of Directors are defendants in a consolidated lawsuit. Plaintiff has been granted leave to file an amended complaint on or before April 15, 2003. Further information about this lawsuit is presented within the Notes to the Consolidated Financial Statements — Contingencies — Shareholder Derivative Lawsuits on page 56.

Hub Services. Nicor Gas offers interstate transportation and storage services, which are regulated by the Federal Energy Regulatory Commission (FERC), as well as certain intrastate interruptible transportation and storage services which are regulated by the ICC. During a periodic rate case that was filed with FERC in 2002, Nicor Gas determined that refunds were due to certain customers of these services. Nicor Gas has refunded service fees and interest totaling $1.1 million, and in the fourth quarter of 2002 it accrued $.3 million for additional costs. Refunds were recorded as a reduction to revenue in the periods that original billing occurred. On March 14, 2003, FERC issued an order approving a settlement with Nicor Gas.

Other FERC Matters. In 2002, Nicor Gas determined that it may not have complied with regulations of FERC governing the release of certain transportation and storage capacity that it contracts for with interstate pipelines, and the company brought these matters to the attention of FERC. The company accrued a $.4 million liability associated with these matters in the fourth quarter of 2002. On March 14, 2003, FERC issued an order approving a settlement with Nicor Gas.

Mercury program. Future operating results may be impacted by adjustments to the company’s estimated mercury program liability or by mercury-related recoveries. Additional information about this program is presented in the Notes to the Consolidated Financial Statements — Contingencies — Mercury Program beginning on page 57.

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 the Notes to the Consolidated Financial Statements — Contingencies — Manufactured Gas Plant Sites beginning on page 59.

Other contingencies. The company is involved in legal or administrative proceedings before various courts and agencies with respect to rates, taxes and other matters. See the Notes to the Consolidated Financial Statements — Contingencies beginning on page 53.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (concluded)

CAUTION CONCERNING FORWARD LOOKING STATEMENTS

This document includes certain forward-looking statements about the expectations of Nicor and its subsidiaries. Although Nicor believes these statements are based on reasonable assumptions, actual results may vary materially from stated expectations. Actual results may differ materially from those indicated in the company’s forward-looking statements due to the direct or indirect effects of the results of legal contingencies (including litigation) and the resolution of those issues, including the effects of an ICC review. Other factors that could cause materially different results include, but are not limited to, weather conditions; natural gas and electricity prices; fair value accounting adjustments; health care costs; insurance costs; borrowing needs; interest rates; credit conditions; economic and market conditions; energy conservation; legislative and regulatory actions, results, or adjustments; additional adjustments related to Nicor’s retail energy marketing joint venture; asset sales; significant unplanned capital needs and any future mercury-related charges or credits. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this filing. Nicor undertakes no obligation to publicly release any revision to these forward-looking statements to reflect events or circumstances after the date of this filing.

Item 7A. Quantitative and Qualitative Disclosures about Market Risk

For disclosures about market risk, see the Market Risk section beginning on page 22, which is incorporated herein by reference.

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Item 8. Financial Statements and Supplementary Data

30

INDEPENDENT AUDITORS’ REPORT

To the Shareholders and Board of Directors of Nicor Inc.

We have audited the accompanying consolidated balance sheets and statements of capitalization of Nicor Inc. and subsidiaries (the Company) as of December 31, 2002 and 2001, and the related consolidated statements of operations, common equity, comprehensive income, and cash flows for each of the three years in the period ended December 31, 2002. Our audits also included the financial statement schedule listed in the Index at Item 15(a)(2). These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and the financial statement schedule based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Nicor Inc. and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

As discussed in the New Accounting Pronouncements — Energy Trading Revenues note, to the consolidated financial statements, the Company has changed its method of accounting for energy trading activities.

DELOITTE & TOUCHE LLP

Chicago, IL
February 28, 2003

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Consolidated Statements of Operations
(millions, except per share data)