The legal marijuana industry has come an exceptionally long way in a very short period. As recently as 2005, recreational cannabis was illegal everywhere, just a small handful of U.S. states were allowing medical marijuana to be prescribed by a physician, and a Gallup survey found that just one out of three Americans supported legalizing weed at the national level.
Today, two out of three Americans surveyed by Gallup favor legalizing pot nationally, 33 U.S. states have given the green light to medical marijuana (including 10 that also allow recreational cannabis), and Canada has become the first industrialized country worldwide to legalize adult-use cannabis. Having brought in close to $10 billion in global sales in 2017, the duo of Arcview Market Research and BDS Analytics expects the global weed industry to net $31.3 billion in annual sales by 2022.
Everything would seem to be perfectly conducive to growth throughout North America. But what you may not realize is that Canada's supply chain is in some pretty deep trouble.
Currently, Canada is contending with a serious pot shortage
Right now, Canada is contending with a supply shortage that could last up to two more years. This supply shortage is being caused by a combination of factors.
For starters, growers are still in the process of building out their capacity. Since committing to expansion often required substantial investment, pot growers weren't able to start on capacity expansion for the recreational market until they were certain that the Cannabis Act would be signed into law. That certainty didn't really manifest until December 2017/January 2018. In other words, growers got a pretty late start ramping up production to meet domestic demand.
As an example, The Green Organic Dutchman (NASDAQOTH: TGODF) is likely a top-five producer at 195,000 kilograms in forecast peak output, according to its management team. Yet, until recently, The Green Organic Dutchman hadn't even made a sale. The company will continue expanding cultivation space in 2019, but The Green Organic Dutchman isn't expected to be running on all cylinders until sometime next year.
Packaging solutions have been another near-term problem. Regulatory agency Health Canada has laid out specific guidelines that growers and retailers need to follow with packaging in order to ensure that products are eligible for sale in licensed dispensaries. These stringent requirements have caused a packaging shortage, leaving unfinished cannabis (i.e., unprocessed but harvested flower) waiting in the wings.
Lastly, but arguably most important, Health Canada's review process for cultivation and processing licenses, as well as sales permits, has bogged down the process. Through March 15, the regulatory agency had issued 159 licenses and permits, but had a much larger backlog. As of May 2018, it was taking nearly a year, on average, for Health Canada to process sales permit applications. As long as the review process remains arduous, expanding supply in the early going will be tenuous, at best.
Big trouble awaits Canada's cannabis supply chain
However, pot shortages won't last forever. In fact, rampant oversupply could be set to hit sooner than some folks realize, according to an updated data point from Health Canada, says Marijuana Business Daily.
Based on data from Health Canada, the number of cultivation license applications currently in backlog stood at nearly 840 -- yes, nearly eight hundred and forty -- as of January 2019. That's up more than 40% from the 588 cultivation applicants that were in queue as of August 2018, and the approximately 500 applicants waiting in the wings for approval in May 2018. When combined with already approved licensed producers, we're essentially talking about 1,000 licensed producers in Canada -- a country that maybe hits $6 billion in annual weed sales by 2022, if everything goes right.
To be blunt (and punny), there's no way that Canada can support 1,000 licensed producers, let alone 200.
What happens if domestic supply gets out of hand? For that answer, just look at Colorado, Washington state, or Oregon. In each of these adult-use legal states, oversupply has run rampant, causing the per-gram price of dried cannabis flower to drop precipitously. Oregon's supply chain has been particularly troublesome since the state doesn't limit the number of licenses that can be issued. If even a couple of hundred licensed producers make it to market in Canada, the country will be glutted with so much dried flower that wholesale and retail prices will plummet.
Marijuana stocks have three ways to combat the coming glut
With even Tilray's (NASDAQ: TLRY) CEO Brendan Kennedy confirming that a cannabis glut is on the way, growers have three ways to combat this mess: grow rapidly, diversify their product portfolios, or expand internationally.
Domestically, growers that can garner a lot of market share upfront may be able to protect themselves from rapidly declining per-gram dried flower pricing. For example, Canopy Growth (NYSE: CGC), the largest pot stock in the world by market cap, expects to have 5.6 million square feet of cultivation capacity fully licensed by the end of this year (it already has more than 4.3 million square feet licensed by Health Canada). This square footage, at industry average yields, could allow Canopy Growth to generate up to 550,000 kilograms a year in peak output. Having large grow facilities, Canopy will be able to take advantage of economies of scale, thereby lowering its per-gram production costs below most mid-sized and small growers. In short, Canopy Growth will have the ability to keep its margins positive, whereas smaller players may not.
A second means of combating the expected dried flower glut is by focusing on alternative products, such as oils. In 2018, Tilray wound up recognizing 49% of its sales from extracts (i.e., cannabinoid-based products). Alternative consumption options typically have a much higher price point than dried flower, but there's also less supply and little to no pricing pressure. By honing in on oils and alternative options other than dried flower, larger producers like Tilray can avoid much of the impending margin crunch.
Third and finally, growers can circumvent any domestic oversupply by exporting their product to overseas markets (where legal). Aurora Cannabis (NYSE: ACB), which projects to be the largest producer by peak annual yield at 700,000 kilos, has cemented its presence via distribution or cultivation deals in 24 countries, including Canada, Having these overseas sales channels available will allow Aurora Cannabis to move product outside of Canada and to markets where demand is sufficient to not hurt per-gram dried flower pricing. Plus, with Aurora's focus on medical marijuana patients, it should be less exposed to dried flower to begin with.
Long story short, growers that are unprepared for the coming cannabis glut will face dire consequences.
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