Fixed Price Contract versus Incentive Based Contract in the Oil Industry

Abstract

This paper analyzes the difference between the fixed price contract, common in the Oil & Gas industry, and the uncommon incentive based contract. Our study shows how the two contracts affect the profits and time usage differently. Both actors prefer the incentive based contract when the project is completed in less than the estimated time and the service provider’s variable income is low, or the project is completed in more than the estimated time and the punishment is intermediate. The operator prefers the fixed price contract and the service provider prefers the incentive based contract when the project is completed in less than the estimated time and the service provider’s variable income is high, or the project is completed in more than the estimated time and the punishment is lenient. The operator prefers the incentive based contract and the service provider prefers the fixed price contract when the project is completed in more than the estimated time and the punishment is harsh. Both actors never jointly prefer the fixed price contract. The two actors collectively always prefer the incentive based contract. That neither individual maximization nor joint welfare analysis causes both actors to jointly prefer the fixed price contract is remarkable given its current prevalence. 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 contract, fixed price contract, moral hazard, adverse selection, profit, cost

JEL Classification: D21, D82, D86, L14