Call it too much of a good thing. Investors have been weighing everything about the cannabis industry ahead of its legalization in Canada – from where it will be sold to a legal consumption age – but could there be a mammoth oversupply to be concerned about? Or are regulators just stoking heated competition?
Marijuana producers, both medical and recreational, have been debuting IPOs on the market every other week and established operations are proposing massive increases in growing capacity across the sector.
Many are banking on the industry to skyrocket, clinging to Health Canada estimates that 450,000 patients will consume 150 tonnes by 2024. To put it in perspective, Canadian producer MYM Nutraceuticals Inc. plans to produce 150 tonnes by itself once it completes construction of it’s 1.5 million sq. ft. facility, one of the largest greenhouse operations on Earth.
Supply and demand predictions from experts are varied. It is challenging to judge the demand of an illegal product and even more challenging to estimate how demand will change once recreational cannabis becomes legalized in Canada.
Image via MYM Nutraceuticals.
The Parliamentary Budget Office is estimating a market size of around 655 tonnes in 2018, rising to 734 tonnes by 2021. The retail market this year is expected to grow to around $4.7 billion to $6.5 billion.
GT Research looked at the regulatory, financial and biological elements to Canadian production and came away with a nearly similar estimate that Canadians will consume around 474 tonnes, rising to 861 tonnes by 2022.
However, there are multiple ways to measure demand. The report also found that people who try cannabis for the first time after they turn 25 is just 1.4%. Half of those go on to use it less than 12 times over their entire lives. New consumers could be stifled, as the most frequent customers are also price sensitive, which we will look at later as the legal market competes with black market prices.
Financial advisory firm Deloitte found a similar level of apathy among Canadians and marijuana in its 2016 study, noting that 22% of respondents say they use marijuana some of the time. This study also estimates that the entire market size would be around $22.6 billion to start.
Finance blog Grizzle released a report online recently estimating demand across Canada will level out around 800 tonnes a year for the next four years. According to their graph below, the supply explosion is expected to start by 2020.
Image via Grizzle.
On the more generous end, the Marijuana Policy Group, a firm that provides analysis and investment advice for industry demand, says could exceed 900 metric tonnes by next year.
As the industry juggles preparing for 700 – 900+ tonnes of demand, what kind of output are Canada’s growers actually capable of?
Another finance blog, The Motley Foolcrunched the numbers and found that the combined output from Canada’s biggest licensed cannabis players would result in a conservative estimate of 1500 tonnes of capacity by 2020 (give or take 100 tonnes).
What could possibly turn people off of legal marijuana? The price is hardly an incentive for new consumers. The federal government is looking to add an excise tax of $1 per-gram, or 10% of the final retail price, and divide the funds equally between Ottawa, the provinces and territories. Though it would drive up the price of pot, it is expected to add another $1 billion in tax revenues a year.
However, looking back to GT’s report, it could drive consumers to turn to the black market. 37% of heavy consumers who drive the market responded that they would not buy from the legal market at a $1 premium, which would increase the price of a gram in Canada to roughly $10, depending on where it is purchased, versus an average of $7.50 - $8.00 on the current black market.
One country that has spent the past year straightening out its legal marijuana practice is Uruguay. A report by the director of Uruguay’s cannabis regulatory authority, Martin Rodriguez, found that interest surged when cannabis was legally sold through pharmacies, with registration rising from 4,900 to over 13,000 in the first month, rising as high as 22,000 registered purchasers (this is a country with a population of 3.4 million).
The report admits the government overestimated the market demand as one of the reasons for a supply glut, but also the work done to limit the size of the market made it more desirable. Only two cultivators were authorized, and consumers were limited to how much they could purchase each month (up to, but no more than 40 grams). Just 12 pharmacies, most in Uruguay’s capital of Montevideo, are licenced to sell cannabis. There are differences between the proposed Canadian legal framework and Uruguay’s model, but some similarities remain to learn from.
To undermine black market sales, Uruguay set a competitive price for its cannabis at $2.50 (USD) or $3.20 (CDN) per gram, which is 70.75 Uruguayan Pesos. This price was mainly chosen because it was equal to black market prices. Given the average household income is around $900 (CDN) a month, the cost of living is lower than Canada, but the price for marijuana is roughly the same as what Uruguayans pay for domestic beer. What could happen in Canada if there was a wide disparity between legal and illegal prices?
Canadian think-tank the C.D. Howe Institute asked this very question and found that not only is the government not doing enough to squeeze out the black market by offering competitive prices, it is actually going to help the off-market industry grow once legalization is fully passed. To be competitive, the report recommends that the federal tax rate should not exceed the GST’s rate at 5%.
“Assuming a pre-tax price of $7.50 per gram, a 5% sales tax results in about 88% of the market shifting to legal consumption and $216 million in federal tax revenues.”
Image via C.D. Howe Institute.
“A newly accessible legal supply at a low price—made possible in part by low taxes— will result in a decrease of the black market and has the public health benefit on encouraging more consumers to use regulated product.”
The report found that illegal suppliers saw a boom in businesses in markets where cannabis had been legalized, such as Colorado. Washington went from a shortage to a supply glut of legal pot in just six months. If the Canadian market doesn’t succeed in making the legal market more appealing than the illegal market, consumers will turn toward the cheaper alternative, even if it means being exposed to a marijuana product that is substandard versus the premium variety.
What would happen if there was too much supply and not enough demand? In April 2018, Québec-based producer The Hydropothecary Corp.(TSX V.THCX, HYYDF, Forum) was the latest Company to make its debut on the TSX Venture Index. Chris Damas, editor of The BCMI Report spoke to BNN to say the sector is over-valued. He is concerned that the business has no supply discipline and suggests production quotas and stricter supply management to ensure investors don’t see a repeat of the speciality pharma biotech stock bubble from 25 years ago.
“The bad news is, these guys are between a rock and a hard place. Either they are going to cut each other’s throats – by flooding the market – or they’re going to pay the master, which is the LCBO [Liquor Control Board of Ontario], and the equivalent in Quebec. Either way, they’re never going to make enough profits to substantiate these valuations.”
The assumption that cannabis growers can’t produce enough product to satisfy Canada’s demand appears to be fictitious. If it isn’t rectified soon, either by capping production or bringing the legal price more in-line with the black market, those same growers will have a massive backlog of cannabis. As any seasoned grower will tell you, marijuana dries out quickly.