3 Reasons Canadian Marijuana Prices May Plunge

The big day is now less than four weeks away. On June 7, Canada's Senate will vote on bill C-45, which is better known as the Cannabis Act. This bill aims to make recreational marijuana legal for purchase by adults 18 years of age and over. If approved by the Senate, the Cannabis Act likely will move swiftly through Canada's federal government, allowing it to become the first developed country in the world to legalize adult-use pot.

With conservatives in the minority at the moment and a two-year tax-sharing agreement in place with all but one Canadian province, everything appears to be in place for C-45 to soon become law. Recreational sales are expected to commence roughly eight to 12 weeks following approval, meaning sometime in August or September.

Most importantly, the legalization of recreational weed is expected to result in around $5 billion in added annual sales for Canadian growers, processors, distributors, and retailers. This comes on top of what's already being generated from medical weed sales and exports. The expectation from investors -- given the stratospheric valuations most pot stocks currently possess -- is that this legalization will lead to big profits for Canadian marijuana stocks.

Yes, cannabis prices could decline significantly in Canada

But what if that turned out not to be the case? What if operating margins for cannabis growers come in significantly lower than expected as a result of falling per-gram marijuana prices? Don't think it could happen given the expectation of strong demand? Think again!

Here are three good reasons why cannabis prices might plunge in Canada shortly after recreational sales commence.

1. Big growers are purposefully trying to drive out smaller players

The first reason marijuana prices might plunge is because the industry's largest players are purposefully overproducing cannabis in an effort to drive down per-gram prices and margins. Why would a large grower overproduce cannabis on purpose? Simple: to drive out competitors that don't have the financial means to survive in a lower-margin environment.

Smaller pot growers don't have the same access to capital as large players like Aurora Cannabis (NASDAQOTH: ACBFF) or Canopy Growth Corp. (NASDAQOTH: TWMJF). Aurora and Canopy Growth have a respective $333 million and $311 million in cash and cash equivalents on hand and are expected to produce in the neighborhood of 430,000 kilograms and 500,000 kilograms of cannabis annually when at full capacity. Virtually nothing is stopping them from ramping up capacity, burying Canada in supply, driving down margins, and putting smaller players that won't benefit from economies of scale out of business. If this all sounds somewhat familiar, it's because this is pretty much what Walmart has been doing to mom-and-pop stores for decades.

2. No one has any clue how much consumer demand to expect

Secondly, since no other developed country has ever legalized recreational marijuana before, it's difficult for growers to get an idea of what consumer demand might look like when the proverbial green flag waves this summer. In plain English, they're flying blind, producing as much as they can, crossing their fingers, and hoping everything works out.

In some ways, this approach has its merits. For example, growers with a lot of upfront production by this coming summer probably have the greatest chance of securing lucrative long-term supply deals with provinces and retailers, as well as forming emotional attachments with consumers. Growers that won't complete their ramp ups until next year or 2020 could miss out on these easy-money opportunities. Therefore, blindly pumping out as much production as possible from the get-go appears to be a good idea on the surface.

The issue is that, without understanding underlying demand trends, the industry runs the risk of dramatically oversupplying the domestic market. Most reports have suggested that Canadians will demand around 800,000 kilograms a year by 2020. However, with giants like Aurora Cannabis and Canopy Growth probably producing more than 900,000 kilograms between them, it's not hard to see how aggregate production across the industry could top 2 million kilograms by 2020 with ease.

While exports may resolve some of this excess supply, there's no guarantee that they will offset all of it. This ignorance to demand could cause per-gram cannabis prices to plunge.

3. Euphoria wears off, leading to a lull in demand

Finally, it's not uncommon for consumer demand, vis-a-vis euphoria and tourism, to taper off a few months after legalization, resulting in oversupply that drives down cannabis prices.

When Colorado and Washington state legalized recreational marijuana in November 2012 and began selling to adults in 2014, cannabis prices on a per-gram basis were very high. Not long thereafter, though, prices fell dramatically. In Washington state, per-gram prices fell from nearly $25 in August 2014, the month after adult-use sales commenced in the state, to just $6 per gram by October 2016.

Understandably, Colorado and Washington don't offer a market the size of Canada, so things could go differently for our neighbor to the north. However, in practically every instance of recreational legalization in U.S. states, we've witnessed a subsequent drop-off in per-gram prices within a matter of a few months to a year following legalization. The odds would seem to favor a drop in cannabis prices shortly following legalization.

What does all this mean? Ultimately, I think it serves as a warning that Canadian pot stock profits and margins could disappoint investors. With this industry already commanding quite the premium, investors can ill afford any surprises.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.