The marijuana movement in North America is seemingly unstoppable at the moment. Mexico legalized medical cannabis in June 2017, 29 U.S. states have legalized marijuana in some capacity since 1996, and Canada stands on the verge of becoming the first developed country in the world to legalize adult-use cannabis by this summer. That's what I'd call a great recipe for rapid sales growth within the marijuana industry.
According to cannabis research firm ArcView in partnership with BDS Analytics, North American legal weed sales grew by 33%, to $9.7 billion in 2017 and they're expected to hit approximately $47 billion annually by 2027. Growth like this is tough for investors to ignore, which is a big reason why marijuana stocks have ascended to the heavens.
The U.S. cannabis industry is rife with risk
But the cannabis industry isn't without its own unique set of risks. Within the United States, for example, cannabis is still a Schedule I drug at the federal level. In short, this means it's entirely illegal, considered to be highly prone to abuse, and has no recognized medical benefits.
Though states have been able to legalize the drug via statewide or legislative votes, federal law still supersedes state regulations outlined in the Controlled Substances Act (CSA). In other words, this house of cards could come crashing down if the federal government suddenly decided to enforce a strict interpretation of the CSA. Though the chances of that happening are unlikely, anything is possible with ardent cannabis opponent Jeff Sessions leading the Department of Justice.
Aside from this gray cloud, marijuana-based businesses also struggle as a result of the federal Schedule I classification. Most cannabis businesses have little or no access to basic banking services such as a line of credit or even a checking account. This is because under a strict interpretation of the CSA, banks fear monetary or criminal repercussions by aiding pot-based businesses.
Likewise, profitable weed businesses also get hit with a more than three-decade-old tax rule known as Section 280E. This rule disallows businesses that sell a federally illegal substance from taking normal corporate income-tax deductions. The end result is an effective tax rate than can be as high as 90%!
And these aren't even all the issues U.S.-based pot growers could face.
Oregon growers are being forced to adapt amid a marijuana glut
As reported by the Associated Press, a marijuana glut in the state of Oregon is forcing growers in the state to adapt their business models or deal with severely depressed margins. Like a handful of other states that have legalized recreational pot, such as Washington and Colorado, all weed grown within the state has to stay within its borders.
However, unlike its neighbor Washington, Oregon hasn't placed a cap on the number of licenses to be issued for cultivation. The result of this free-for-all is an absolute glut of dried cannabis within the state.
According to AP, there's nearly 450,000 kilograms of marijuana (nearly 1 million pounds) floating around in the system and little way to dispose of it. Because of this glut, per-gram cannabis prices have collapsed by 50% since 2015, falling from $14 per gram to just $7 per gram, according to the Oregon Office of Economic Analysis.
While some producers in Oregon are simply learning to cope with depressed margins in a saturated market, others have adapted by turning to hemp and its medical byproduct, cannabidiol (CBD). Next to Colorado, Oregon has moved to the No. 2 spot in terms of hemp production (hemp is the cannabis plant's cousin that can be used in a variety of industrial purposes). Additionally, the tetrahydrocannabinol (THC) content -- the psychoactive component of cannabis -- in hemp is just 0.3% compared to as much as 30% THC content for cannabis plants.
The move makes sense considering that CBD commands a significantly higher price point than dried cannabis, which has become borderline commoditized and targets a niche consumer base. CBD is often revered for its medical benefits, although clinical studies have been hit-and-miss, depending on the indication.
Cannabidiol is gaining added limelight in the U.S. given the expectation that the Food and Drug Administration (FDA) will approve GW Pharmaceuticals' (NASDAQ:GWPH) lead drug Epidiolex next month. GW Pharmaceuticals' drug sailed through pivotal-stage trials and delivered a statistically significant reduction in seizure frequency relative to the baseline when compared to the placebo for two rare types of childhood-onset epilepsy. There's never been a cannabinoid-based drug approved by the FDA before, giving GW Pharmaceuticals a chance to make history and perhaps persuade the U.S. federal government to adjust its stance on CBD, as a whole.
Could Canada follow in Oregon's footsteps?
The big question is, given what we're witnessing in Oregon, will Canada follow suit and switch its production away from dried cannabis in favor of oils and extracts or even hemp?
Before we dive in, understand that there are two pretty significant differences between Oregon's cannabis market and that of Canada -- and I'm not talking about population or size. First, Canada allows its cannabis to be exported beyond its country's borders, providing a possible means of reducing excess supply. The other difference is that Health Canada, which regulates the Canadian cannabis industry, does somewhat limit the number of cultivation licenses. Therefore, there's not as much of a free-for-all nature to growing pot in our neighbor to the north as there is in Oregon.
Still, talk of a domestic glut in Canada if the Cannabis Act is signed into law in June is very real. Most reports would suggest that domestic demand will equate to roughly 800,000 kilograms a year. Comparatively, full capacity production for Canada's dozens of licensed growers may top 2 million kilograms by 2020 or 2021, leading to more than 1 million kilograms in annual oversupply. What happens to this excess pot?
Some of it likely would be exported to foreign countries that've legalized medical marijuana. But it's unknown if demand in these foreign nations will be strong enough to offload more than 1 million kilograms of annual domestic oversupply. If it isn't, per-gram cannabis prices -- and margins -- could tumble.
Interestingly enough, Canadian growers aren't sitting idly by to see if this scenario plays out. They've been incorporating cannabis oils and extracts into their product lines in greater numbers.
Canopy Growth Corp., the biggest pot stock by market cap, announced in February that 23% of its third-quarter sales were from oils, up from 13% in the year-ago quarter. Similarly, Ontario-based MedReleaf noted in its most recent quarterly results that 21% of total sales were derived from oils, up from just 3% in the year-ago period.
Canadian growers also are being ushered in the direction of higher oil and extract output, given that foreign countries with medical marijuana laws haven't necessarily given the OK for patients to use dried cannabis. CBD oil, for instance, is almost universally accepted in these countries. Plus, physicians typically favor that their patients take oils rather than smoke cannabis.
Ultimately, it's probably a bit early to suggest that Canada is going to turn out like Oregon. However, it's not out of the question that Canadian growers shift their production to hemp and CBD in the years that lie ahead in order to escape some combination of domestic oversupply or cannabis commoditization. It's certainly a situation that bears close monitoring.