The 3 Biggest Risks Facing Canada's Legal Marijuana Industry

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This has been nothing short of a transformative year for the legal cannabis industry. On June 19, Canada's Senate approved an amended version of Bill C-45, which is more commonly referred to as the Cannabis Act. Effectively, this approval allows Canada to become the first industrialized country in the world, and the second overall behind Uruguay, to green-light the sale of recreational marijuana to adults.

According to Prime Minister Justin Trudeau, who has long lobbied for the legalization of marijuana, the Cannabis Act will officially go into effect on Oct. 17, 2018. The nearly four-month delay between its passage and the proverbial green flag waving is to give retailers enough time to get product in their stores, as well as to allow provinces time to get their regulatory infrastructure in place.

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For investors, this approval is considered by some to be nothing short of a Holy Grail opportunity to get rich. With a medical cannabis market worth just a few hundred million domestically, a green light for adult-use marijuana is expected to add up to $5 billion a year in sales. Between domestic demand and the ability to ship cannabis products to foreign markets where medical weed is legal, the table would appear to be set for marijuana stocks to prosper.

The biggest risks facing Canada's legal weed industry

But before you uncork the champagne, understand that the pot industry still has some kinks to hash out. Though financing is no longer a concern following passage of the Cannabis Act, three risks still remain for the Canadian legal marijuana industry.

1. Regulatory worries

One of the biggest surprises is that although the Cannabis Act has passed, regulations, or a lack thereof, within Canada could disrupt the legal pot industry.

As an example, one of the most prominent concerns raised by opponents of Bill C-45 was the idea that legal access to cannabis would increase the number of people driving under the influence of the drug. Though driving while under the influence of marijuana data is somewhat limited, there is no question that cannabis impairs drivers.

However, legislation that would grant law enforcement additional authority to conduct testing on drivers believed to be under the influence of cannabis have yet to be passed by the House of Commons or Senate. This creates a substantial gray area with regard to how people suspected of driving under the influence of cannabis will be dealt with by law enforcement.

Making matters worse, though there are a handful of marijuana-based breathalyzers in development at the moment, some of which are being tested on a small scale by law enforcement, none are ready for mass adoption. Cannabis is a potentially tricky drug to detect in a user's system because, unlike alcohol, the tetrahydrocannabinol (THC) that gets users "high" can stick around for days or weeks. This makes establishing recency of use, and thus impairment, much tougher.

Understand that this is just one of example of how regulation could prove to be a push-pull catalyst on the legal cannabis industry.

2. Supply concerns

Believe it or not, cannabis supply could actually be a big problem for the Canadian legal weed industry.

Generally speaking, strong demand and limited supply is a good thing. It tends to keep the price of a good high, which can ultimately buoy the margins of the businesses selling that good.

Initially, there's expected to be a shortage of cannabis in Canada, which should inflate the per-gram price of dried cannabis. Though we know the Cannabis Act is approved now, there were no guarantees of its approval seven or eight months ago. This meant most growers were hesitant to approve projects costing tens or hundreds of millions of dollars back then. As a result, despite breakneck capacity expansion, most projects won't be complete until between mid-2018 and the end of 2020.

For instance, Aurora Cannabis (NASDAQOTH: ACBFF) is expected to complete is 800,000-square-foot Aurora Sky project anytime now, which'll yield 100,000 kilograms a year. Meanwhile, OrganiGram Holdings, which should be among the largest players, won't complete its expansion at its flagship Moncton, New Brunswick, facility until April 2020. These staggered project completions significantly increases the likelihood of an initial supply shortage.

What's more, there are two under-the-radar issues pushing down the potential of the Canadian legal pot industry... and they both relate to Health Canada. The regulatory agency overseeing the rollout of legal marijuana is responsible for approving cultivation licenses for growers. The problem is that there's a backlog of more than 500 licenses at the moment waiting for approval. It often takes months to years to review these production license applications.

Secondly, even if a grower gets a thumbs-up from Health Canada to begin licensed production, it then needs to obtain a sales permit for its cannabis. On average – I repeat, on average – it takes 341 days to get approval once a sales permit application is filed with Health Canada, according to Marijuana Business Daily.

If there's a persistent shortage of marijuana, the per-gram price of dried cannabis has the potential to increase. But if it goes up too much, it may coerce users to turn to black market channels. Remember, the black market has virtually no traditional overhead costs. There are no storefronts to maintain and no federal taxes to pay -- the federal excise tax rate is about 10% per gram. Even though the black market is illegal, it could easily undercut legal channel pricing and slow or halt the pace at which consumers move into legal sales channels.

In short, yes the margin boost from a shortage is nice, but an extended shortage could prove disastrous.

3. Long-term oversupply

And then there's a problem at the opposite end of the spectrum: the possibility of a glut of weed supply.

What investors have to remember is that there is no precedent to a country of Canada's size legalizing recreational marijuana. But what we do know from Washington, Colorado, and Oregon to the south is that the legalization of recreational marijuana usually leads to an oversupply over time and a precipitous decline in per-gram dried cannabis prices.

On the surface, oversupply would be welcome for consumers since it would probably lead to a decline in per-gram cannabis prices. Of course, it's bad news for marijuana growers as it would threaten to shrink margins. Economies of scale would certainly come into play here, with larger growers being able to handle a significant decline in per-gram prices, while small- and mid-sized growers could find themselves in trouble.

While production is incredibly fluid, my expectation is that aggregate Canadian production could hit an annual run rate of 2.5 million kilograms by the end of 2020. In fact, the four-largest producers -- Aurora Cannabis, Canopy Growth Corporation, Aphria, and The Green Organic Dutchman -- are on track to produce 1.5 million kilograms between them by 2020. Comparatively, Health Canada has suggested that domestic demand will only total around 1 million kilograms.

So, what happens to what could be 1 million to 1.5 million kilograms in oversupply? The hope is that it'll be gobbled up by foreign markets where medical marijuana is legal. But keep in mind it's not that simple. Even with more than two dozen countries having legalized the use of medical weed, not all are importing or allow dried cannabis, preferring instead to only allow oils. Finding a home for so much excess supply could prove tougher than many pundits expect -- and if a home for all of this expected oversupply can't be found, a precipitous decline in per-gram prices and margins could follow.

There's no doubt that these are exciting times for Canada's legal weed industry, but it's certainly not without risks.

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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.