Although predicting the future of the legal cannabis landscape in Canada is fraught with risk, there is enough information available to encourage informed speculation. I envisage a substantial oversupply in the market in the near future, and a likely correction that will lower stock valuations. Further, oversupply should lead many small growers and producers to leave the market; more mergers and acquisitions will take place; and the illegal market will keep pushing prices down.
The 2017 run-up in cannabis stock market valuations on the Canadian Securities Exchange (CSE) suggests a highly profitable future, even after a correction in 2018. While week-to-week valuations fluctuate, the CSE currently values marijuana stocks at just north of $40 billion.
However, a legal cannabis market that accounts for a substantial share of the total market and that yields the profit levels implied by current stock valuations requires a combination of conditions that are incompatible: a large legal market share will necessitate a competitive legal price; but a competitive legal price will not yield a sufficient profit margin to generate returns that are consistent with a $40-billion market capitalization.
In order for the stock market valuation to stay at $40 billion, with an annual return of 6 percent before tax, the industry would require a profit flow, net of all costs, of $2.4 billion per year. It is difficult to see how this number could be achieved on the basis of domestic sales alone — even with medical and recreational products combined. The marijuana market before legalization involves about 800 tonnes of flower equivalent; so if 60 percent of that becomes legal, the legal trade would amount to 480 million grams. To generate a profit margin of $2.4 billion, the profit per gram would have to be $5. Even if the legal market were to account for three-quarters of all sales, the required profit margin per gram would be $4.
Average retail costs in the US account for $3 to $4 per gram. Wholesale prices (an average from outdoor, greenhouse and indoor/warehouse growers) are in the region of $3 per gram. With costs totalling approximately $7 per gram, it is difficult to see how cannabis could be priced at a sufficiently low price to both generate substantial profit and garner a large share of the total market. The street price of cannabis flower is currently in the $5 to $6 range.
The implied profit margins required to justify today’s stock valuations are unlikely even in the future, when the market reaches a stage of maturity and when other products with potentially higher margins, like edibles and concentrates, become more readily available. Since much of the Canadian economy will be served by high-wage government-owned monopoly outlets, retailing costs may be higher than in the US, which will therefore make a competitive price more difficult to attain.
The medical market might provide higher margins to suppliers than the recreational market if private and public drug insurance plans decide to include medical cannabis use. Insurance coverage could entice recreational users to portray themselves as having medical needs for cannabis, which could lead to a reduction in the recreational component of the market. In addition, if Canadian producers become international cannabis-market leaders, then exports and foreign subsidiaries would have the potential to generate profit. But such expectations may be optimistic. In particular, if the cannabis trade were to be covered in a new NAFTA agreement involving Mexico, as has been advocated recently by the former president of Mexico, Vicente Fox, then Canadian producers could be dramatically squeezed. The ability of Canada’s “Big Cannabis” corporations to develop expertise in medical marijuana and their ability to generate substantial returns on that expertise in international markets will be determining factors in their long-term value.
The dynamics of the supply side point to continued downward pressure on prices and margins as a result of the enormous production capacity currently being planned. As of summer 2018, approximately 110 production and sale licences have been granted by the federal government, and many more firms may be licensed by late 2019. By some estimates, the legal sector will have twice as much supply as the current illegal market, even with no new suppliers coming in. In particular, Deltabot Capital points out that just the top five cannabis producers in Canada have a stated objective of reaching a production capacity of about 1,000 tonnes by the end of 2019. This sum excludes the capacity of literally scores of other producers. All told, in the near future, we might see a supply capacity of almost three times the existing illegal market — two times the current illegal market becoming available in the legal sector, plus the existing illegal capacity.
As a result, margins will be squeezed in both the legal and illegal markets. Excess capacity in legal markets will drive down the price that growers will receive from retailers. And excess supply in illegal markets should drive down street prices, which will in turn impact the legal market. With pressures on both street prices and retail prices, it is difficult to envisage what a market “equilibrium” will be in 2020 or 2021. But it may involve consolidation among suppliers, and the exercise of monopsony (sole-buyer) power by government-agency wholesalers and retailers, in the form of downward pressure on prices paid to suppliers.
Ultimately, the producer marketplace will consist of several large companies and many medium and small players. The large firms will benefit from economies of scale, while the smaller players will tout their artisanal brands. A supply glut also increases the risk of legal supply being sold in the illegal market.
As of mid-2018, provincial retail agencies were signing contracts with suppliers. It would be in the public interest to have the details of these contracts made public — particularly the negotiated prices. This information could be valuable to those producers on the margin of profitability and to potential entrants into the industry. Information might deter some from entering and generating further excess supply. Restricting the number of new licences would likely have little impact on oversupply, because of the production capacity already in place or on the drawing board. Such a policy could also inhibit innovation.
The supply side of the cannabis marketplace in Canada will continue to be a dynamic, changing environment after legalization. A supply glut in the medium term should have knock-on effects in the form of reduced stock valuation and downward price pressure from illegal markets. Open, transparent purchasing arrangements between governments and suppliers could help to stabilize supply and reduce stock price volatility.
This article is part of The Economics of Canadian Cannabis special feature.
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