Big things are happening in the legal cannabis industry. Our neighbor to the north, Canada, has inched one step closer to legalizing recreational marijuana. Bill C-45, which is best known as the Cannabis Act, should be signed into law shortly, allowing for legal adult-use weed sales to commence by some time in August or September.
This expected legalization is a long time coming for marijuana enthusiasts and pot stock investors. In fact, bill C-45 first made its way to Canada's Senate 14 months ago, and was only voted on after numerous debates, speeches, and amendments, a few days ago. However, the snail's-pace progress of the Cannabis Act has been overlooked by investors given that $5 billion or more in sales awaits once adult-use marijuana is made legal.
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Of course, waving the proverbial green flag for cannabis in a developed country has never been done before. Therefore, there's no precedent in terms of what the market should expect with regard to supply or demand. Produce too little cannabis, and growers could be missing out on the ability to grow their market share and sales. Produce too much marijuana, and growers could decimate their margins by driving down the per-gram price of legal weed.
Canada may face an initial weed shortage
Though no one knows with any certainty what the supply and demand picture will look like in Canada, it currently appears to be gravitating toward a pretty substantial marijuana shortage. Under such a scenario, marijuana's per-gram price, and thus the margins of growers, should be incredibly strong.
Why a shortage, you ask? To begin with, though most Canadian growers are expanding their production capacity as quickly as their balance sheets will allow, most need a good year, or more, to complete organic builds or retrofits.
For example, Aphria (NASDAQOTH: APHQF), which currently slides in as the third-largest Canadian producer by yield at 230,000 kilograms of dried cannabis annually, isn't expected to complete is organic build of Aphria One, or its retrofit of the partnered Aphria Diamond facility, until January 2019. This means that the bulk of Aphria's production won't be ready for harvest for at least another half year. Of course, Aphria isn't alone. There are plenty of other growers with projects that'll take them well into 2019, or perhaps 2020. The ramp-up of pot production in Canada will be staggered, which likely means a marijuana shortage in the early going.
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To build on this point, the legalization of marijuana in a developed country is liable to create a sense of euphoria among citizens, tourists, and perhaps even the export partners of Canada's growers. In other words, initial demand for the first couple of months is likely going to outpace what becomes a relatively steady amount of month-to-month consumer demand. This initial euphoria surrounding legalization could further exacerbate an early supply shortage.
Canada's under-the-radar marijuana supply issue
However, these front-and-center supply issues only tell half the story. There's another under-the-radar problem that could seriously suppress Canadian marijuana supply in the years to come.
As reported by Marijuana Business Daily, the number of applicants to cultivate marijuana has surged on a year-over-year basis. Through the first four months of 2018, Health Canada has received 74 licenses to grow marijuana, which compares to the 30 licenses received through the same period of 2017. There are now more than 500 cultivation applications in Health Canada's pipeline for review, with those reviews usually lasting anywhere from six months to a few years.
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While that might seem like great news from a supply perspective, it also takes Canada's regulatory agency a long time to also approve permits to sell cannabis -- an average of 341 days to be exact. No grower has received a quicker turnaround on requesting a sales permit to being approved than CannTrust Holdings, which was lucky enough to receive a sales permit just 129 days later.
Right now, there are 104 companies that are allowed to grow marijuana. However, just 48 are permitted to sell cannabis, while an even fewer 25 have the OK from Health Canada to sell high-margin cannabis oils and extracts. Even if growers get the OK to plant and harvest their crop, they may not be able to sell their cannabis until well into 2019 or 2020. And, might I add, this impacts growers of all sizes, including Aurora Cannabis and Canopy Growth Corp., which are far and away expected to be the two largest producers by annual yield.
Without a more efficient way to streamline sales permits, Canada could be facing a supply shortage well into 2020.
An overshoot is also likely
Though a supply shortage is probably the best news possible for marijuana stock investors as it'll buoy dried cannabis margins, I wouldn't rule out the possibility of growers overshooting on supply by as early as 2020 or 2021. The thrill of initial demand and the strength of early marijuana shortages might cause growers to throw caution to the wind and lead to unbridled expansion.
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According to a report from Health Canada, domestic weed demand should come in around 1 million kilograms per year. However, based on the peak production capacity of the largest players, along with the dozens of cultivation licenses issued by Health Canada, production by 2020 or 2021 could hit 2.4 million kilograms per year, by my best estimate. That would mean having to abate an oversupply of around 1.4 million kilograms. Even if foreign countries are willing to buy the bulk of this oversupply, there are no guarantees that they'll be able to absorb it all. In effect, the commoditization of dried cannabis beyond 2020 or 2021 could begin to wreak havoc on the margins of marijuana growers.
Ultimately, we probably won't have a good bead on the Canadian cannabis supply and demand outlook until a few years after legalization. But from the perspective of an investor, I wouldn't count on any initial oversupply lasting too long or aiding investors all that much.
