Abstract: 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.
The oil and gas industry on the Norwegian Continental Shelf (NCS)1 currently experiences cost increases and reduced productivity. Costs related to rig-hire and oil services are among the largest cost drivers in drilling projects combined with a reduction in drilling productivity (Osmundsen et al., 2008). Main challenges for Integrated Operations' on the NCS are moral hazard, adverse selection, and high monitoring and coordination costs (Osmundsen et al., 2008; Sund, 2008). Unfortunately, contracts that tie actual performance to incentives are practically absent on the NCS. Questions emerge whether this absence has affected the recent cost increases and productivity decreases.
Uncertainty often exists in inter-organisational relationships. Information is often asymmetric. The principal can obtain information by inspecting or evaluating the distinctive tasks performed by the agent, or by developing incentive-based systems which ensure that the agent's behaviour is in the principal's best interest. This means designing incentive systems that favour all collaborating actors to contribute for the best of those involved (Eisenhardt, 1989). Principal-agent analysis has two distinctive challenges. The first is moral hazard related to post-contractual opportunism, where the principal cannot be sure whether the agent has put forth maximal efforts as its action is difficult to observe. The agent may then pursue its own interests. The second is adverse selection, which is a pre-contractual situation with asymmetric information where the principal cannot be certain that the agent accurately performs the work for which it is paid. The agent's action can be difficult to observe and the agent may pursue its own interests. Moral hazard and adverse selection occur with the use of a fixed price contract, which has a fixed payment per day for one unit of work and is to be considered as a low powered contract, in the sense of providing weak incentives.