What is Take or Pay
Take or pay is a provision, written into a contract, whereby one party has the obligation of either taking delivery of goods or paying a specified amount.
BREAKING DOWN Take or Pay
Take or pay provisions are generally included between companies with their own suppliers which require that the purchasing firm take a stipulated supply of goods from the supplier by a certain date, at the risk of paying a fine to the supplier if they don't do so. This sort of agreement primarily benefits the supplier by reducing their risk of losing money on any capital spent to produce whichever product they are trying to sell.
Take or Pay in Practice
Take or pay provisions are very common in the energy sector, because of the huge overhead costs for suppliers of supplying energy units like natural gas or crude oil. The overhead costs of providing crude oil as compared to a haircut, for example, are very high. Take or pay contracts provide energy suppliers an incentive to expend capital up front because they have a measure of assurance that they'll be able to sell their products.
For example, Firm A can pledge to purchase $200 million worth of natural gas from the supplier, Firm B, over a period of 10 years at an agreed rate of $20 million per year. Firm A may find, however, that in a given year they will only need $18 million worth. If they do not purchase the planned $20 million, they will be subjected to a fee, which is agreed to in the original contract. Typically these fees are smaller than purchase price; having forgone $2 million in purchased natural gas, Firm A may be subject to a fee of $1.5 million.