Uh-Oh! Marijuana Prices Are Plunging, and You're Not Going to Be Happy With the Reason Why

By Sean Williams Markets Fool.com

The marijuana industry was one of the brightest stories in an otherwise chaotic 2016.

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Heading into November, residents in nine states were set to vote on various recreational and medical cannabis initiatives and amendments. With the exception of Arizona, which had its recreational-marijuana initiative rejected by just 2%, it was a clean sweep for pot in every other state. Two other states, Ohio and Pennsylvania, approved medical-cannabis laws entirely through the legislative process (i.e., without putting a measure on the ballot for residents to vote on). By year's end, 28 states were now considered medical cannabis-legal, while the number of recreational-pot states had doubled to eight.

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The dollar figures behind pot have also been enormous. ArcView estimates that legal marijuana sales hit $6.9 billion in 2016 and that they could continue to grow by approximately 30% through the end of the decade. With an estimated 87% of marijuana sales ($46 billion) still tied to the black market, there's an ample opportunity for legal sales to continue surging higher.

Marijuana prices are plunging for a potentially scary reason

But beneath this rapidly growing facade is an industry that could soon find itself in deep trouble if certain market dynamics continue to deteriorate.

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As Forbesreported last week, wholesale marijuana prices are plunging in legal-marijuana markets. According to CannaSaver.com CEO Brian Shapiro, wholesale prices plummeted 60% in 2016, from $2,500 per pound to just $1,000.

In Washington state, the decline in marijuana prices was even more pronounced, albeit over a longer timeframe, according to BDS Analytics. In August 2014, just a month after recreational marijuana became available in Washington's pot dispensaries, the average selling price per gram was nearly $25, though the amount of marijuana being produced was minimal. A year later, the price had fallen to roughly $10 a gram, as more than 3 million grams were produced. By October 2016, the price had fallen to approximately $6 per gram, while production had increased to well over 6 million grams.

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What's particularly worrisome about the drop in wholesale marijuana prices is that it's an entirely supply-side issue. Growers are flooding the market with cannabis at a faster rate than consumers can buy it, despite growth in the demand side, causing prices to plunge.

But it's not the existing businesses that have created this mess. Instead, Douglas Brown of Contact High Communications noted in his interview with Forbes that new, larger entrants into the growing side of the equation are responsible for flooding the market with pot. Pro-legalization enthusiasts have often shunned the idea of allowing big business into the marijuana industry for fear that small businesses would be squeezed out. It would appear that's exactly what's happening to the few states where recreational weed is legal.

Big business is pushing its weight around in the cannabis industry

If the price per pound of marijuana continues to fall, it could be great news for consumers, but it would be horrific news for marijuana businesses and potentially even the state governments that pushed for the legalization of recreational cannabis.

At $1,000 per wholesale pound, as reported by CannaSaver.com, marijuana businesses are already seeing their margins pinched. The only two solutions in response to lower wholesale prices are to try to cut costs with advanced new growing technologies, which often mean an initial investment before cost savings are recognized, or to win the volume game. Many of these larger players have chosen the latter by flooding the market with pot and piling on the profits even with lower margins.

Image source: Getty Images.

But it's not a fair fight. Because the federal government maintains a Schedule 1 status on marijuana, signifying that it has no medical benefits and is thus illegal, pot businesses are often unable to gain access to basic banking services such as a checking account or line of credit. This situation leaves many smaller dispensaries and grow farms to solely deal with cash, which is both a security risk and an inhibitor of growth.

Big businesses don't have this problem. They usually have deep enough pockets that they can survive pushing wholesale prices and margins significantly lower and driving out their competition. If there are fewer small-business growers, then the remaining big businesses can throttle back production and eventually raise their prices.

State governments are concerned, too

In the interim, the plunge in wholesale pot prices is also concerning to state governments. Because states such as Colorado and Washington rely on the total sales of marijuana products to generate revenue, lower prices could lead to less in tax revenues collected despite growing public demand for marijuana products. If prices were to continue falling, it could necessitate a look at tying marijuana taxes to volume grown or sold, as opposed to the actual dollar figure of what the consumer purchases.

Image source: Getty Images.

California, for example, will be taxing growers on a volume basis once the infrastructure of the industry is up and running. Prop 64 established a cultivation tax of $9.25 per ounce on flowers and $2.75 per ounce on marijuana leaves. California's volume-based tax could become more popular if pot prices keep falling.

For investors, falling wholesale prices are a mixed bag. On one hand, lower margins are never a good thing for businesses, meaning marijuana stocks could feel a pricing power pinch across the board. However, one of the bigger issues for investors at the moment is that there aren't many publicly traded investment opportunities involved in the marijuana industry that offer real promise. Industry consolidation and the elimination of smaller players could create that handful of marijuana stocks that allow investors to finally participate in pot's rapid growth.

Moving forward, wholesale costs are worth paying very close attention to if you've entertained the idea of investing in the marijuana industry.

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