How to evaluate a buy-back contract? An Economics of Information Model

Moral hazard in contracts, especially international oil contracts, is a key subject under the economics of information. In this article, considering the oil and gas industry specifications, oil contracts and moral hazard models, the proper model for evaluating buy-back contracts. Since moral hazard from both parties could be seen in oil contracts and both are maximizing their profit, despite the standard models, the employer (client) should consider two incentive constraints for both principal and agent. Accordingly, standard model is not proper to evaluate this type of contracts and two sided moral hazard models are more in compliance with oil contracts. The results say that in two sided moral hazard and non observable action of both party, no contracts touch first best conditions. In addition, short term essence of buy-back contracts, predefined proceeds of contract before starting point, fix interest rate, non flexibility of contract and defined obligations before operation, non flexibility of payment method from oil proceeds and lack of comprehensive reservoir study results in lack of incentive for selection of more optimal methods for for development oil fields with higher costs for maximizing mutual interests. Accordingly, buy-back contracts are not a second best optimal contract.