GAS DISTRIBUTION

Nicor Gas typically accounts for about 90 percent of Nicor Inc.'s consolidated operating income. The company is widely regarded as one of the best companies in the natural gas distribution industry, and it consistently ranks at or near the top of its industry in terms of operating efficiency and financial returns.

Nicor Gas delivers natural gas to 1.9 million customers in a service territory that encompasses most of the northern third of Illinois, excluding the city of Chicago. The company's customer base consists of a well-balanced mix of residential, commercial and industrial customers, and the region's diverse economy helps to reduce the potential impact of adverse conditions in any specific industry.

Financial Results. Gas distribution operating income decreased to $185.5 million in 1998 from $210.1 million in 1997 due to the impact of weather that was 23 percent warmer than the prior year, partially offset by a 4 percent reduction in operating and maintenance expenses.

Natural Gas Deliveries. This past year was the warmest of this century in northern Illinois, and the unusually warm weather had an adverse impact on demand for natural gas in Nicor Gas' service territory. For the year, natural gas deliveries were 487 Bcf compared with 545 Bcf in 1997. The negative impact of warmer weather was partially offset by several positive factors, including an increase in deliveries for electric power generation, the addition of new customers, and efforts to promote increased use of natural gas among existing customers.

The Choice Is Yours. The utility industry has changed significantly in recent years, and consumers are finding that regulatory changes and increased competition are leading to new alternatives.

Nicor Gas supports customer choice and believes all customers should be able to choose their natural gas supplier. Almost all of the company's industrial natural gas deliveries are to customers who already buy some or all of their natural gas from third-party suppliers. To make choice an option for even more customers, Nicor Gas launched its Customer Select ® test program in 1998, and 20,000 commercial and industrial customers, the maximum allowed to enroll, chose to participate. In September 1998, the company received approval to open the program to an additional 40,000 business customers and 80,000 residential customers beginning in 1999. In all instances, Nicor Gas will continue to deliver natural gas to the customer, provide for the safety and maintenance of its distribution system, and read customer meters.

Building on Our Strengths. As the utility industry has changed, Nicor Gas has focused on its strengths. The company has an extensive storage and transmission system that provides significant flexibility when it comes to serving the needs of customers. The system interconnects with six interstate pipelines-including the new Northern Border pipeline-and additional interconnects are likely in the future as new pipelines come into the area. This gives Nicor Gas an enviable supply position and helps keep customer prices low.

Historically, Nicor Gas' low prices have given the company a competitive advantage versus electricity in northern Illinois, and have also gone a long way toward ensuring a high level of customer satisfaction. The people of Nicor Gas are also one of the company's strengths, providing the ability to anticipate and adapt to changes in the industry.

Working to Achieve Growth. While some opportunities in the energy industry are best pursued through unregulated entities (see "Other Nicor Ventures" on pages 13 and 14), there are still opportunities to achieve growth in the gas distribution business. Nicor Gas has averaged about 30,000 customer additions per year in recent years, and has also worked hard to achieve additional deliveries to existing commercial and industrial customers through focused sales and marketing efforts. However, deliveries can be adversely affected when customers replace old equipment with newer, more energy-efficient equipment.

To help achieve growth at Nicor Gas, the company has pursued a variety of opportunities. Over the past few years, for example, Nicor Gas has put itself in position to serve the market for electric power generation. In 1998, deliveries of natural gas for electric power generation increased to 50 Bcf, up from 40 Bcf the prior year and 22 Bcf just two years ago.

Nicor Gas has also had success in nontraditional activities, finding innovative ways to utilize its physical assets by providing natural gas storage and intrastate transportation services. These and other nontraditional activities contributed over $8 million to operating income in 1998.

Is There Anything Else I Can Do for You? An essential element of any effort to achieve growth is outstanding customer service. Nicor Gas has devoted significant effort in recent years to improving upon an already high level of customer satisfaction by asking the customer, "Is there anything else I can do for you?"

Nicor Gas strengthened its commitment to customers in 1998 by implementing a toll-free telephone number and by revising its bill format in response to customers' desire for a more "understandable" bill. The company also implemented measures to enhance the billing process and the way customer inquiries are resolved.

To continue building on these efforts and successes, Nicor Gas is taking advantage of every opportunity to listen to customers and understand their needs, and to develop and deliver solutions that create value. This may mean developing products and services not currently offered, or improving existing services to better serve customers. The people of Nicor Gas will continue to make other changes-large and small-to keep the Nicor promise of "unconditional personal service for each and every customer."

The Keys to Success. As the people of Nicor Gas look to the future, they are focusing on a number of key issues that must be addressed in order to achieve success.

Growth: With a diverse and growing customer base, an extensive storage and transmission system, and a favorable location on the nation's natural gas pipeline grid, Nicor Gas has achieved favorable returns and cash flow at a time when significant changes are taking place in the gas distribution industry. The company plans to continue to pursue a combination of both traditional and nontraditional activities in order to achieve growth and capitalize on new opportunities.

Customer Care: Nicor Gas is strengthening its commitment to customer satisfaction by working to better understand customer expectations, focusing on employee training and education, and measuring and monitoring its progress against improvement goals. One of the objectives is to build loyalty to the Nicor brand, and customer input during the past two years indicates a high degree of customer satisfaction and loyalty.

Employee and Organizational Excellence: Nicor Gas strives to be recognized by both employees and the communities it serves as a great place to work. In order to achieve those objectives, the company works to promote leadership and teamwork internally, and focuses on shared values and the employee behaviors that support those values in order to create a high-performance work culture.

Technology: Many of Nicor Gas' initiatives require technological solutions. Accordingly, a key issue for 1999 is to establish a framework to optimize the uses of technology to accomplish business strategies.

Cost Management: In the past, Nicor Gas has successfully focused on tightly controlling costs while maintaining system integrity, and will continue to do so in the future. Over the years, cost management and ensuring reliability have become part of the corporate culture at Nicor Gas.

SHIPPING

Tropical Shipping, one of the largest carriers of containerized cargo in the Caribbean region, typically accounts for about 10 percent of Nicor's operating income. The company has a reputation for providing quality and on-time service and has earned leading market shares in many of the ports it serves.

Nicor has owned Tropical Shipping since 1982, and over the years the company has contributed significantly to earnings growth and cash flow at Nicor.

Financial Results. In 1998, Tropical Shipping again achieved record volumes shipped, revenues and operating income. Operating income was $27.6 million, up from $25.3 million in 1997, due to an increase in volumes shipped and higher average rates.

Year in Review. For the year, Tropical Shipping transported 144,200 TEUs compared with 138,500 TEUs in 1997 as the company increased volumes in nearly every region it serves.

The company also continued its efforts to increase efficiency and reduce costs. Tropical Shipping operates a fleet of 13 owned and 5 charter vessels, and in 1998, the company modified its vessel schedule in order to reduce the number of weekly port calls, streamline the handling of containers, and free up vessel capacity.

Tropical Shipping also increased its overall capacity by upgrading its charter vessels. The fleet is carefully managed to avoid overcapacity in any given market, and to ensure the optimum combination of cargo mix and speed.

Tropical Shipping also made a significant investment in new freight equipment in 1998. Taking advantage of container prices that were very low compared to historical levels, Tropical Shipping purchased over 1,100 containers in 1998, increasing its overall capacity and replacing a significant portion of older and leased containers.

Industry Developments. On October 1, 1998, the U.S. Congress passed the Ocean Shipping Reform Act. This Act has an effective date of May 1, 1999, subject to implementation regulations to be issued by the Federal Maritime Commission by March 1, 1999. The Act allows confidential contracts between shipping companies and their customers, and many believe this change will put downward pressure on ocean shipping rates. Additionally, global carriers are establishing a presence in the Caribbean market.

Outlook. Tropical Shipping is meeting the challenge of deregulation and increased competition through effective cost management, superior customer service and its premier fleet and shore assets. The company's primary goals continue to be:

• building close ties with customers;
• being the "low-cost" competitor through on-time, efficient cargo handling and vessel scheduling;
• developing diversified revenue sources;
• managing costs to maintain a competitive advantage; and
• developing a talented workforce.

Although the Caribbean marketplace has matured significantly, growth opportunities remain. Most of the region is economically and politically stable, and Tropical Shipping is pursuing opportunities to increase volumes in markets it already serves, expand geographically in the region to new markets, serve additional U.S. ports, and continue to expand in nontraditional niche businesses.

In addition, Tropical Shipping is considering updating its fleet by adding new vessels with greater capacity which are capable of higher speeds. The company has not added to its fleet of owned vessels since 1993, and since that time, the volume of shipments handled by Tropical Shipping has grown by 50 percent. The company has relied on charter capacity to handle the increase in volumes, but expanding Tropical Shipping's owned fleet may be a more economical way to meet the company's long-term needs.

Overall, Tropical Shipping is well-positioned for continued success in the Caribbean. The company is financially strong, competitive and poised to build on its status as the quality, dependable transportation company in the Caribbean.

OTHER NICOR VENTURES

As the natural gas and electric utility industries are further deregulated, Nicor is continually looking for opportunities to provide products and services that will meet customers' changing energy needs-and for innovative ways to generate new revenue or contribute to earnings per share growth. What follows is an update on Nicor's unregulated energy-related businesses and financial initiatives.

Nicor Energy. Nicor Energy is a joint venture between Nicor and Dynegy Inc. Nicor Energy's initial focus is on providing natural gas products and services to small- and medium-sized commercial and industrial customers-as well as to eligible residential customers-in the greater-Chicago area.

Looking ahead, Nicor Energy is focusing on increasing its customer base and enhancing overall business processes to better serve customers. The company's initiatives include adding to its customer base in northern Illinois, expanding geographically, developing electric capabilities and initiating electric sales campaigns where allowed by regulatory changes, and refining information technology systems and other business processes.

Electric Power Generation. The market for electric power generation can be divided into three segments: small commercial generation, mid-sized commercial generation, and large industrial or wholesale generation. Already well established in the market for mid-sized commercial generation projects, Nicor provides service to customers as a developer and general contractor for cogeneration projects. Nicor's success in this segment of the market is one of the reasons the company decided to explore other electric power generation opportunities. Regarding the market for small generation needs, Nicor signed a memorandum of understanding in 1998 with General Electric (GE) Power Systems that gives Nicor exclusive rights to market GE microturbines in Illinois and Wisconsin. Nicor also announced an alliance with Dynegy that gives Nicor the ability to pursue large electric power generation projects in the Midwest. One such project, a 250-megawatt, natural gas-fired electric generation plant, is under construction in Illinois. Overall, the market for electric power generation represents a significant opportunity for Nicor.

Supply Ventures. Regulatory changes and the arrival of Canadian gas supplies through the Northern Border Pipeline are increasing the importance of Chicago as a natural gas hub. This, in turn, opens up significant growth opportunities for Nicor. Approximately 3,600 Bcf of gas is consumed in the five-state Midwest region annually, and the commodity changes hands many times en route to market. Nicor continues to explore ways to facilitate these transactions and to otherwise participate in this evolving marketplace by entering the wholesale gas trading business and capitalizing on the value of the Nicor storage and transmission system, as well as its interconnects with interstate pipelines.

Other Nonregulated Businesses. Nicor's developing businesses build on the company's strengths and its expertise in the utility industry. These small, but strategic, businesses are providing a variety of unregulated products and services, including appliance service contracts; turnkey natural gas fueling services; and consulting, product testing and commercialization for the natural gas industry.

Other Investments. Nicor has made a number of financial investments in recent years. These investments are in cargo container leasing and affordable housing tax credit funds. The payback period on these investments is typically very short, and they quickly generate incremental cash flow for Nicor. Nicor's financial investments in 1998 totaled $23 million.