In 108 more days, Canada will make history. According to Prime Minister Justin Trudeau, and following the passage of the Cannabis Act (officially Bill C-45) less than two weeks ago, adult-use marijuana will go on sale in approved dispensaries throughout Canada on Oct. 17. This will make Canada only the second country in the world, and the first industrialized nation, to have legalized recreational weed.
What does legal marijuana mean from a financial perspective, you wonder? How about the addition of somewhere in the neighborhood of $5 billion in annual sales. This comes atop the revenue marijuana businesses are already generating from the sale of cannabis to medical patients in Canada and via exports to countries where medical pot has been legalized. This expected meteoric rise in sales over the short and intermediate term, along with rapidly expanding capacity, is what's lured investors in droves to Canada's pot stocks.
The irony behind Canada's marijuana legalization
Yet there's an interesting irony that lies behind the legalization of marijuana in Canada, and the expected green rush that's less than four months away from hitting the market. Namely, that dried cannabis isn't the product that growers are necessarily going to be focus on.
Don't get me wrong, in the first couple of months to perhaps a year following legalization, more traditional cannabis products are liable to be strong sellers. With the proverbial green flag waving on Oct. 17, it appears very likely that there will not be enough marijuana available to meet demand. The reason for this being that growers had to wait until it appeared certain that the Cannabis Act would pass before they spent exorbitant amounts of money on capacity expansion. This has left most pot stocks with staggered completion dates for their major capacity-expansion projects that range between the summer of 2018 and the end of 2020.
For example, Aurora Cannabis (NYSE:ACB) has suggested that it could lead the pack by producing 570,000 kilograms of cannabis-equivalent production yearly, when at full capacity. But when Oct. 17 rolls around, it's not going to be anywhere near this level. Its 800,000-square-foot Aurora Sky facility will be done by then, and it's capable of just over 100,000 kilograms of cannabis production annually, but its recently announced Aurora Sun facility in Alberta, and its partnered Aurora Nordic project, won't be completely online until a later date.
This is the case with pretty much every grower in Canada, which should lead to a domestic cannabis shortage through perhaps 2019. Assuming this thesis is correct, a shortage of cannabis with strong demand should buoy or lift the per-gram price for dried cannabis.
Dried cannabis could fall victim to oversupply and commoditization
However, beginning in 2020 or 2021, when all of these staggered projects have reached completion, the annual production run rate could hit 2.4 million kilograms of cannabis or higher. This would (likely) create a more than 1 million kilogram oversupply domestically, which would coerce these growers to export their oversupply overseas. If any of these growers struggled to sell their cannabis to foreign markets, it could tank dried cannabis prices.
Even if this worst-case scenario doesn't occur, oversupply is a problem that's reared its head in Colorado, Washington, and Oregon -- the first three states to have sold recreational weed legally in the United States. All three states have witnessed a significant and precipitous decline in the per-gram price of dried cannabis that began not too long after retail sales commenced. While economies of scale will help bigger operations survive a significant decline in the price of cannabis, it's pretty evident that, based on what's happened in a select few U.S. states, it's a product susceptible to commoditization. So it's probably not a top-tier priority for cannabis growers beyond 2020.
Here's what has the Canadian cannabis industry (and investors) intrigued
Rather than devoting their attention to dried cannabis, growers will be focusing on alternative products that bear significantly higher margins and are much less susceptible to commoditization. This includes cannabis oils and extracts, edible products, and even cannabis-infused beverages. It's worth pointing out that edibles won't be legal come Oct. 17, but amendments included in the Cannabis Act give parliament the ability to discuss and add edibles to the existing framework in the future.
Cannabis oils are a particularly popular product that a number of large and mid-tier growers are focusing on. In addition to garnering a higher price point and juicier margins than dried cannabis, oils are a valuable export product.
Despite more than two dozen countries having legalized medical cannabis, not all of these countries allow patients to smoke dried cannabis. What's more, physicians generally dislike the idea of prescribing a medicine that needs to be smoked. Meanwhile, cannabis oils are almost universally accepted by countries where medical cannabis is legal, and they're a go-to prescription for physicians in these countries. Putting two and two together, growers that make oils a focus should have strong demand for their product domestically and overseas, along with higher margins than their peers.
Among existing growers, none has devoted more attention to oils in the early going than CannTrust Holdings (NASDAQOTH:CNTTF). More than half of the company's sales from its most recent quarterly report were derived from oils, with the remainder coming from dried cannabis. Admittedly, CannTrust is still in the process of expanding its flagship Niagara Greenhouse facility, which will boost its share of dried cannabis production. But it's pretty evident that CannTrust's management team understands the importance of product diversification.
Infused beverages could be another very interesting dried cannabis alternative. Molson Coors Brewing (NYSE:TAP) is rumored to be looking for a marijuana partner to develop cannabidiol (CBD) and/or tetrahydrocannabinol (THC)-infused beverages. THC is the psychoactive component that gets you "high," while CBD is the nonpsychoactive component best known for its medical benefits. Molson Coors has seen its share of the Canadian beer market shrink over the past decade, and most alcohol companies are now facing the possibility of losing sales to legal cannabis. By partnering, Molson Coors could add a new channel of sales, as well as share a higher-margin product with a top-tier grower.
In short, while dried cannabis might be the oft-talked about centerpiece of legalization, it'll likely take a back seat to cannabis alternatives over the long run.