Inderscience Publishers

Fixed price contract versus incentive–based contract in the oil and gas industry

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The research question of this paper is to analyse when an operator and a service provider prefer a fixed price contract, common in the oil and gas industry, versus the uncommon incentive–based contract. The contracts are modelled with 20 parameters and one free choice variable which is the time to complete the project determined by the service provider. The method is to determine the service provider's first order condition and compare the two actors' profits for the two contracts. The actors' preferences for the two contracts are presented with analytical inequalities and graphic illustrations. We show when both actors, versus only one actor, prefer(s) the incentive–based contract. Both actors never jointly prefer the fixed price contract. The two actors collectively always prefer the incentive–based contract. This result follows since costs associated with moral hazard, adverse selection, monitoring, coordination, etc. decrease with the use of an incentive–based contract.

Keywords: incentive based contracts, fixed price contracts, moral hazard, adverse selection, profit, cost, oil and gas industry

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