The marijuana industry is budding before our eyes, and investors who've been willing to take a chance on this still-illegal industry have probably been handsomely rewarded. Since the beginning of 2016, most pot stocks have rallied by a triple- or quadruple-digit percentage.

Though there are no shortage of reasons why marijuana stocks have soared, the primary catalyst continues to be the expected legalization of recreational cannabis in Canada. Should Canada approve bill C-45, better known as the Cannabis Act, it would become the first developed country in the world to have legalized adult-use weed, and in the process, it will open the door to billions of dollars in added annual revenue. It's worth pointing out that Canada legalized medical pot back in 2001, and it's one of just two countries (along with the Netherlands) that's actively exporting marijuana to foreign countries that've legalized medical weed.

Dried cannabis buds next to a piece of paper that says yes, atop miniature Canadian flags.

Image source: Getty Images.

What might domestic Canadian weed demand look like?

The big question, though, is this: What sort of demand should growers, retailers, and anxious investors expect in Canada once the proverbial green flag waves?

There is no precedent to an economy of Canada's size giving the thumbs-up to legal marijuana, so formulating estimates as to what to expect has included more guesswork than normal. Most provincial estimates and Wall Street reports have called for approximately 800,000 kilograms of domestic annual demand. However, a report issued last month by Health Canada, the regulatory agency responsible for overseeing the legal cannabis industry, as well as issuing cultivation and sales licenses, projects that domestic demand will be notably higher.

According to an April 2018 prediction from Health Canada, domestic cannabis demand is expected to reach 1 million kilograms (2.2 million pounds) by the end of 2018, or approximately 25% higher than most consensus estimates. With production in April tallying around 300,000 kilograms countrywide, this implies a supply deficit of about 700,000 kilograms of dried cannabis. 

Even with domestic growers expanding their production capacity as quickly as their balance sheets will allow, it'd be a stretch to expect supply to meet demand -- especially when this demand includes exports to foreign markets (primarily in Europe) -- before mid to late 2019. Such a scenario suggests that pot stocks will see rapidly rising sales, and likely rising margins. Higher margins would be a function of steady or rising cannabis prices on a per-gram basis, as well as economies of scale working in favor of pot stocks and driving down growing costs as their operations expand.

Dried cannabis in jars laid out on a counter.

Image source: Getty Images.

The big worry

Initially, the Canadian cannabis industry might look like the greatest thing since sliced bread. A supply deficit, along with the initial euphoria of recreational marijuana becoming legal, should result in some impressive year-over-year comparisons. But what's worrisome is what could happen once a plethora of greenhouse projects are complete and pot stocks reach their full production capacity.

While annual production estimates remain fluid given the abundance of dealmaking in the cannabis space, just a handful of Canada's largest producers are on pace to deliver well in excess of Health Canada's projected domestic demand. Keeping in mind that these totals are subject to change, here's what production should look like when these growers are fully ramped up.

  • Canopy Growth Corp.: approximately 500,000 kilograms (kg)
  • Aurora Cannabis: 430,000 kg
  • Aphria: 230,000 kg
  • MedReleaf (NASDAQOTH:MEDFF): 140,000 kg
  • Emerald Health Therapeutics: approximately 125,000 kg
  • OrganiGram Holdings: 113,000 kg
  • Hydropothecary: 108,000 kg

Just these seven growers are on track to generate 1.65 million kilograms of annual production, partly by their estimates, and partly based on my own projections in the cases of Canopy Growth and Emerald Health Therapeutics.

What's more, these estimates could rise significantly. For example, MedReleaf, which agreed to be acquired by Aurora Cannabis earlier this week, has 95 acres of land adjacent to its Exeter facility in Ontario. With its retrofitted Exeter facility spanning 1 million square feet and capable of 105,000 kilograms a year in production, building out this 95-acre plot could wind up yielding 150,000 kilograms or more in annual yield, should demand merit expansion. 

If we were to add in the mid-tier players like Supreme Cannabis Company, Sunniva, Cronos Group, CannTrust, Cannabis Wheaton Income Corp., and the dozens of additional growers who've been issued a cultivation license, it's not out of the question that production capacity by the end of 2020 could hit 2.3 million to 2.4 million kilograms on an annualized run rate. Even if domestic demand in Canada ebbs higher in 2019 and 2020, production looks to outpace demand by as much as 1.3 million kilograms, by my best estimate.

An assortment of legal cannabis products on a counter.

Image source: Getty Images.

What happens after 2020?

What happens to this excess dried cannabis? The belief is that it'll be exported to foreign markets where medical marijuana is legal. We've witnessed a more favorable stance on medical cannabis throughout Europe, which some analysts predict will gobble up all of this excess demand. However, not all countries have opened their arms to dried cannabis, even if medical weed is legal. Physicians traditionally favor oils and extracts over consumption via smoking, which could doom dried cannabis to a significant and steady decline in per-gram prices beginning in 2020. This would also be expected to negatively affect the margins of Canada's largest growers.

As such, one of the smartest moves Canadian growers can make is in altering their production to include a higher percentage of oils and extracts. Though these products have a narrower consumer base, they also command a considerably higher price point and much juicier margins. Plus, with CBD oils widely accepted in medically legal countries, growers that focus on oils are the likeliest to be able to sell their entire line of products.

Though no one knows exactly how the supply and demand picture will play out in Canada, call this investor seriously concerned about the possibility of a cannabis glut wrecking growers' margins beginning in 2020.

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.