Are Marijuana Prices Already Falling in Canada?

The marijuana industry has taken the stock market by storm in 2018 -- and for good reason. A little more than a month ago, Canada became the first industrialized country in the world to legalize recreational cannabis, which paves the way for Canadian pot stocks to grab their piece of what might be a $5-billion-plus pie. Mind you, this sales estimate from Wall Street doesn't take into account the potential for Canadian-based marijuana stocks to find new overseas sales channels, so it's likely conservative.

Investors turn their attention to tangible results

However, this major marijuana event also signals a transformation in the way investors view and analyze pot stocks. Before Oct. 17 (the day the Cannabis Act went into effect in our neighbor to the north), cannabis companies made pie-in-the-sky promises about production, product diversification, partnerships, and international expansion. And they were typically rewarded for those announcements. Now, with weed legal in Canada, investors will be looking for tangible results that they can wrap their hands around.

Over the past couple of weeks, nearly all the biggest marijuana growers (as measured by projected peak yield) reported their latest quarterly operating results, giving investors their first peek under the hood since legalization -- sort of. The quarters that cannabis stocks are reporting on ended Sept. 30, so there aren't any direct recreational sales being accounted for as of yet. This meant that, for the most part, sales soared, but operating losses skyrocketed even faster as pot stocks willingly spent on capacity expansion, marketing, branding, international expansion, and -- in some cases -- acquisitions.

Are marijuana selling prices already falling?

Truth be told, there weren't too many surprises -- save for one. In a handful of reports, a decline in year-over-year average net selling prices per gram of cannabis was reported.

On Nov. 13, marijuana bottle-rocket Tilray (NASDAQ: TLRY), which galloped from a list price of $17 per share in late July to hit $300 a share on the nose by mid-September, reported a decline in net selling price per gram in the third quarter. Tilray recorded an average net selling price per gram of $6.21, versus $7.53 in the year-ago quarter (Tilray reports in U.S. dollars). The company blamed a year-over-year increase in bulk sales for the substantive decline in the price per gram.

Though you might consider Tilray an anomaly, Cronos Group (NASDAQ: CRON) reported the exact same thing on Nov. 13. Cronos, which could potentially slot in as one of Canada's seven largest growers at peak production, recorded an average selling price per gram of 7.32 Canadian dollars ($5.54), a nearly 9% drop from the CA$8.01 per gram it averaged in sales in the year-ago period.

Presumably, with cannabis shortages being reported in a majority of Canadian provinces and territories, we'd expect per-gram prices to be strong. After all, basic economic principles would suggest that high demand and a supply shortage would drive prices higher. But that's not what we're seeing in the early going, at least with Cronos Group and Tilray.

Near-term price declines may prove benign

You're probably wondering what the heck is going on, since high per-gram selling prices are important in the early going from a margin perspective. The good news is that at least part of this decline is the fault of relatively benign factors.

For example, Tilray blamed an increase in wholesale bulk sales for its sales decline. But it's important to note that the company sold just 1,613 kilograms during the entire third quarter, which was more than double the 684 kilos sold in the prior-year period. Building from such a small base of production, it's not surprising to see wild swings in the average net selling price per gram for cannabis. In other words, if the prior-year quarter included virtually no wholesale bulk sales, and the recently ended quarter does, it can lead to wild per-gram fluctuations in average selling price.

The same probably goes for Cronos Group, which sold a meager 514 kilograms in its latest quarter, up from 164 kilos in the prior-year period.

We may also see volatile per-gram price swings based on the percentage of sales attributed to cannabis oils from one quarter to the next. Oils are a high-margin product relative to dried cannabis flower, but production is still lumpy in the early going for most growers.

Things still look grim for per-gram cannabis pricing over the long run

On the other hand, the long-term price outlook for cannabis remains worrisome. The aggregate production capacity for all growers looks to easily exceed 3 million kilograms, if not approach 4 million kilograms. Yet Health Canada projects that domestic demand will only hit roughly 1 million kilograms by the end of the decade, leading to an annual oversupply that could reach up to 3 million kilograms.

Although foreign markets are expected to gobble up quite a bit of this excess supply, the landscape could change in the coming years. In other words, foreign countries have nascent grow industries now, but that could change. If cannabis grow farms are developed in Germany, or any other European market, it could eat into export demand, creating an oversupply that drives down the per-gram price of cannabis.

Though there's little precedence to recreational marijuana being legal, we've seen this oversupply scenario play out in Colorado, Washington state, Oregon, and to some extent California following the opening of dispensary doors in that state in January 2018. There's little reason to believe that the same thing won't happen in Canada, with growers expanding their production potential without any idea of real demand.

Additionally, some growers may simply be willing to accept higher volume for lower margins. The aforementioned Tilray notes in its quarterly report that it expects per-gram prices to continue to fall as it pushes to include more wholesale bulk sales.

In short, investors would be wise to pay close attention to per-gram weed prices since they could have a material impact on pot stocks' bottom lines.

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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.