Blunt Economics

I’ve posted previously about Canada’s excess production capacity but I now want to look at the over-capacity problem in some more depth, specifically attempting to answer the question “how bad is the situation, really?” One way to think about this is to figure out how long the current capacity glut will last if the industry stops adding more capacity immediately and just lets the market catch up. To do this, we first need to understand how fast the market for Canadian-produced cannabis is likely to grow.

For this post, we’re going to look only at the market as a whole – that is, the combined licensed and unlicensed market. However, doing that involves setting aside the importance of the black/grey market, which I can’t bring myself to hand-wave away without three caveats. 

First, the legal market has, to date, only claimed about one-third of the Canadian cannabis market. Second, Licensed Producers (LPs) are still struggling to compete with black market weed on both price and quality. Third, taking customers away from the black market will keep getting harder. The low hanging fruit is mostly gone. Wooing black market customers now requires actual competitiveness on either price, quality, or both. All that to say, what you’re about to witness is a fairly flamboyant hand wave:

Now let’s ignore the black market and assume that all weed sold in Canada is, or will soon be, sold by LPs.

The Canadian market demand was about 788,000 kg over the last twelve months. Fully licensed capacity crossed over that threshold in April 2019. Capacity has more than doubled from April to September (which is the most recent period of data), increasing at an average rate of 17% per month. The licensed facilities in September had an annual capacity of 1,917,000 kg, 2.4 times the current demand for the whole market.

The two main problems with over-capacity are opportunity cost (any resources spent on developing future production capacity are no longer available to spend on other current business activities) and asset degradation (just like your house or your car, factories have a limited lifetime and continually require expenditures on maintenance and repairs). Neither of these is that big a deal if demand is growing rapidly and quickly catches up to the available capacity.

Therefore, to think through whether, and to what extent, the current situation is a total disaster, let’s consider how long until existing capacity will be needed. It clearly isn’t needed today. But that’s fine if it’s needed tomorrow, and probably isn’t terrible if it’s needed in two, or even three years. But if we find that current capacity won’t be needed for longer than that, the situation starts looking obscene.

How fast is Canada’s cannabis demand increasing?

To figure out how long it will take until the existing licensed capacity is needed, we need to make an assumption about how fast the market is growing.

Two things to keep in mind as we think this through. First, we’re talking about the quantity of cannabis consumed, not the revenue generated by sales of cannabis. The one importance of this distinction is that it allows us to mostly ignore “Cannabis 2.0” as a major factor here. The (frankly insufferable) term “Cannabis 2.0” refers to the introduction of a broader range of cannabis-derived products into the legal market. This includes cannabis edibles (chocolates, gummies, hard candies, drinks, etc.), vapes, hash, topicals, etc. These products are much more profitable than selling dry cannabis; and to an even greater extent, they also bring in more revenue. No surprise there – it’s better to be Goodyear than a rubber farmer – but since our current concern is production capacity, and therefore quantity sold rather than revenue or profit, the mark-up on these products isn’t currently relevant. 

Second, we’re talking about the whole market (legal + black/grey markets), not just the legal market. Therefore, increasing demand, in terms of kilos of cannabis harvested and sold to consumers (regardless of whether it’s sold as dry flower or further processed into edibles or anything else), necessarily requires one of the following four things:

1. Increasing the Canadian population
2. Increasing cannabis exports
3. Increasing the number of Canadians consuming cannabis and/or the amount of pot each of those Canadians consumes

Canadain Population Growth

Canadian Population grew at a rate of 1.1% from 2000 to 2018, and StatsCan predicts population growth of 0.8% for the next fifty years, a slight decrease from the past two decades. So, if nothing else changed we would expect cannabis demand to grow at a rate of 0.8% annually.

Cannabis Exports

The export data is slower to be released than other cannabis data, so it is only available to March 2019, but the picture is pretty clear nevertheless: Don’t count on exports for substantial growth in demand for Canadian cannabis.  Look at the graph of exports as a percentage of production capacity:

There are two things to note here. First, this graph is pretty noisy; there’s no obvious trend that we could easily use to predict where this might be going. The other point to make is that the numbers are very, very small. Exports average less than 0.02% of production capacity. Exports would have to increase fifty-fold to account for even 1% of the current production capacity.

Beyond what we can see in the historical data, there is also a theoretical reason to doubt imminent and explosive growth in cannabis exports: cannabis is highly regulated. And the regulation involved in production for export is only going to be more Byzantine than what is already necessary to produce for the domestic market. Producing for export involves satisfying two totally separate sets of regulations (regulations in both the importing and exporting countries) and doing so simultaneously, which will sometimes be difficult, and other times be impossible. 

One could probably argue persuasively that with enough persistence and ingenuity, you could set up a production system that facilitated export to one, or even multiple international markets. My response to that would be: Sure… but why bother? It will always be easier to set up domestic production. So if you want to sell in an international market, why not just set up a production facility there? It’s not the case that Canada has far cheaper labour or electricity than other places in the world, so there’s no other obvious advantage to producing in Canada and exporting internationally.

Indeed, the largest Canadian cannabis companies are already in the process of building out networks of production facilities in other countries. This fact alone is a strong indicator that the Canadian cannabis export market is not about to blow up.

I know there are people out there who will read this and yell “but what about when the US legalizes weed!?!” Even if that happens tomorrow, I don’t see how that changes anything above. It will still be a bigger hassle to grow in Canada and export it than to grow it stateside, making the resulting product less competitive. Moreover, from what I understand, the existing legal US producers are growing a better product at cheaper prices, making Canadian imports less competitive still. Finally, if it’s legal, there will be nothing to stop Canadian producers from investing in American production facilities; so I don’t see why they would shoot themselves in the foot by trying to do something more difficult. Taken together, I’m not holding my breath waiting for massive export growth.

More Canadians Stoned and/or Stoned More Often

It isn’t ridiculous to think that overall consumption/person might increase over time. There are likely some potential customers who have had their consumption limited by some combination of 1) limited access to a supplier of black-market pot and 2) the stigma of using a black market product. 

According to StatsCan, spending on cannabis spiked by 10% during the first quarter of legalization, compared to the same quarter in the previous year. Some of that was probably driven by people shifting their purchases from cheaper black market weed to more expensive LP weed. But there was probably also a bump in actual consumption. However, that bump fell off as the novelty of legal weed waned. Cannabis spending actually dropped slightly from Q3 2018 to Q3 2019. Adjusting for inflation, spending on Cannabis has only increased by 16% in (constant, inflation-adjusted dollars) since 2000.

Another factor that could promote cannabis demand growth is loosening regulations on marketing cannabis. Current cannabis marketing regulations are much stricter than they are for alcohol, which is demonstrably more dangerous to public health, so I can imagine that those regulations might change. If Canopy Growth sponsored my softball league, that might increase demand but how much? And how soon? Given that per capita cannabis spending in the last two decades only increased by 16%, how much growth can we reasonably expect in the next two? How much more time can we collectively afford to spend high?

Canadian Cannabis Demand Growth: A Floor and a Ceiling

Since I can’t sensibly pick a single, specific rate of growth, I think it makes the most sense to look at a range and see how the situation looks under various scenarios. So we’ll pick the smallest growth rate and the largest and then look at when the current production capacity will be needed under various scenarios in between.

Let’s start by picking the lowest growth rate worth considering. There are some experts who have argued that legalization will have no effect on cannabis use. (Here’s a quick summary of some of that research.) This strikes me as unlikely, but it’s obviously a good floor number. If legalization has no effect on cannabis use and we also assume that the cannabis export industry will never get off the ground, the only factor driving growth will be population growth, at an annual rate of 0.8%. So that’s our floor.

For the highest reasonable demand estimate, I picked 5%. I want to be clear why this strikes me as unreasonably high, and therefore the biggest growth rate I’m considering here. At that rate, the size of the market would double in just under sixteen years. With population growth at 0.08%/year, the 16-year population growth would be less than 14%. With a population that’s 14% larger, a doubling of demand would require average consumption to increase by 76%. This strikes me as very, very large. I think that such an increase in consumption would be seen by many politicians and policymakers as a public health disaster and would result in some kind of action to slow or reduce consumption. So it seems like a reasonable ceiling.

Just How Bad Is the Over-Capacity Problem?

You should now be able to look back at the graph at the top of this post and evaluate the situation yourself. How bad is the current situation? My answer: mind-bogglingly bad.

Keep in mind that this analysis also assumes the total annihilation of the black market. There is no reason to assume that will be simple. Consider that a 2018 Ernst & Young report of the cigarette industry found that 30% of Ontario sales went to the black market. Will eliminating black market cannabis be any easier?

Even in the best-case scenario, in which the black market evaporates and cannabis demand increases at 5% a year (and to reiterate, I think this strains credulity), Canada has more cannabis production capacity than it needs for almost two decades. In the worst case, we’re not measuring time in decades, but in centuries. In either case, by the time that capacity is needed it will be rusted, out-dated, and will have consumed as much money in maintenance costs as it will ever produce in revenue.

Data Sources and Analysis

Health Canada maintains various pages where they post information about licensed cannabis. Data used here come from their pages on dry cannabis (which includes the data on the total area of licensed production space), cannabis oil, and cannabis for medical purposes (which is the source for the cannabis export data). Data on historical rates of Canadian spending on cannabis is taken from StatsCan’s data on Household Consumption.

The numbers used in this post that I had to calculate myself were also used in my previous post on this topic. The methodology used for their calculation can be found in the Data Sources and Analysis section at the bottom of that post. Specifically, that includes the methodology used to 1) calculate total legal + black/grey market demand; 2) translate the data published by Health Canada on the total area of licensed production space to production capacity.

Health Canada recently updated their cannabis market data, adding new data that allow you to calculate the amount of cannabis that was lost, stolen, or destroyed by Canadian Licenced Producers (LPs). It’s a doozy.

During the last year 318,000 kg of cannabis was lost, stolen, destroyed, or otherwise disappeared.

In my last post, I talked about the astonishing extent to which Canadian cannabis companies have over-invested in production capacity. About 16% of weed sold in Canada was sold in the legal market, and the total Canadain market (legal and black-market combined) was about 788,000 kg. Nevertheless, Canadian LPs have built and licensed enough production space to grow more than 2,460,000 kg of cannabis; that’s more than 3.5 times the size of the total Canadian cannabis market and more than twenty times the amount that was sold this past year in the legal market. 

To put that in context: if the legal market doubles in size, then doubles in size again, then doubles in size again after that, then doubles in size still one more time, Canadian LPs could have stopped increasing production capacity back in September 2019 and would still have 35% more capacity than necessary. (Note: this capacity number is higher than I reported in the last post; it’s based on the most recent data available.)

Regardless of how much Canadian LPs could possibly ever sell, they still used a surprising amount of the available production capacity. From October 1st, 2018 to September 30th, 2019, Canadian LPs grew a little more than 750,000 kg of weed, with production ramping up over time. They grew as much as was sold legally over the whole year (~130,000 kg) in just the last month and a half of that period (mid-August to the end of September 2019). 

After selling all the weed they possibly could, what did Canadian LPs do with the rest? They squirreled away a lot of it. But it seems like the majority of it, they just destroyed.

After selling all they possibly could, what did Canadian LPs do with the rest? They squirreled away a lot of it. Inventories ballooned by more than 300,000 kg. But it seems like the majority of it, they just destroyed. During the last year, 318,000 kg of cannabis was lost, stolen, destroyed, or otherwise disappeared. Based on the most recent spot price for wholesale cannabis in Canada ($6.62/gram), that’s north of $2.1 Billion dollars worth of weed. (Note: that’s the price received by producers; retail prices are considerably higher.)

To my knowledge, the data required to know what percentage was lost, what was stolen, and what was destroyed is not publically available. My assumption is that most of it was destroyed. But who knows? All I can tell you with certainty is this: The weed’s gone.

Data Details and Sources

I’ve posted the data in a Google Sheet document. It’s a view-only document, which will allow you to view the formulas used. If you want to play around with the data, you can download it as an Excel sheet or save it to your own Google drive. Although the specific calculations I used are available on that sheet, the overall idea behind the numbers is straightforward and worth being clear about here. 

At any given time, the cannabis inventory in the LP system consists of dried cannabis (see Health Canada’s dry cannabis data) and cannabis oil (see cannabis oil data), which was obviously made from cannabis grown by LPs. About 5 mL of oil can be made from the same cannabis required to produce 1 gram of dried cannabis. Therefore, you can look at all inventory in the system in terms of kilograms of dried cannabis and the dried cannabis equivalent of oil. (The 5 mL/g conversion rate is the same used by Bloomberg, an example of which can be found here.)

Changes in inventory from one period to the next are the net result of all additions to inventory and all reductions to inventory over that period.

The only addition to the LP system inventory comes from cannabis production: growing and drying cannabis within the LP system. Importantly, converting dried cannabis to cannabis oil doesn’t add new material into the system; it just changes its form. Similarly, transfers from one LP to another do not change the level of inventory in the LP system (they just move it from one place to another). In Health Canada’s data, this addition to the LP system is reported within the section on dried cannabis under “unfinished production”. 

The only reductions in LP system inventory that are reported by Health Canada are monthly sales. This includes medical and recreational sales of both dried cannabis and oil. My main interest here is obviously all the other reductions. I calculated this by starting with monthly production and subtracting 1) changes in reported inventory; 2) sales. Again, the details and links to the original Health Canada data can all be found on the Google Sheet linked above.

For anyone who’s followed the coverage of Canada’s weed market, over the past months, you probably know that there’s currently way more weed in inventory than we have the collective lung capacity for bong hits.

But that excess supply isn’t the disease; it’s a symptom. The disease is excess capacity, and we’ve got a stage-four case. The most recent data available is five months old, but even then Canada already had way, way, way more cannabis production capacity than we will ever need. Just look at the graph above.

In June, there was enough licensed production space to harvest 1,670,000 kg of dried cannabis per year. The current demand in the WHOLE MARKET (i.e. the licensed and black market combined) is only 788,000 kg/year. That means that the current legal market capacity is more than two times what is needed to supply both the black and licensed markets. 

Even if the black market just goes away – poof! – and cannabis demand grows at 15% per annum (it won’t come close, but I’ll save the details of how I model market growth for a future post), some of that production space that was built, licensed, full of equipment, and ready to grow in June would lay fallow until at least 2025.

Moreover, the black market still exists. Combining Health Canada numbers with Stats Canada’s estimates of the total size of the cannabis market (details about this below), the legal market currently represents less than a fifth of the total cannabis market (17.4%). Put this all together and it’s very possible that a large percentage of the production capacity that was licensed in June will never grow a single plant.

As for any space licensed since then? It’ll just be worse. And I promise you: there was lots of space that got licensed. If capacity growth was what it was prior to June, we now have the capacity to grow thirty times more weed than was sold in the legal market (recreational and medical combined) in the year since legalization.

What does this mean for the future of the Canadian Cannabis market?

I’ll do future posts on how this will shake out for different market participants (vertically integrated majors, smaller producers, retailers & processors), but here is a quick summary:

Cannabis price/gram will continue dropping across the supply chain.

The extent of this drop will depend on what producers choose to do with all their production capacity. If the bigger players decide not to use large percentages of their capacity, this effect could be limited. Nevertheless, my current assumption is that output will increase substantially and prices will fall accordingly.

Major write-downs of production assets and goodwill.

Any asset that is likely to lay fallow for the foreseeable future will need to be revalued, resulting in large non-cash losses.

Substantial write-downs of processing and packaging assets.

There is no reason to think that misplaced optimism was limited to grow facilities. Processing capacity for oil production, beverage/chocolate/gummy production, vape cartridge production and everything else would have been planned based on estimates of kilos harvested in production facilities.

Fire sales and consolidation.

If any company can maintain investor confidence as this shakes out, the opportunities are huge. That’s a big “if,” but anyone with cash on hand when the panic sets in will be well set up for long-term success once the market stabilizes.

Details & Data Sources

To get the Canadian market’s capacity, I started with Health Canada’s published data on Licensed cultivation area (the last chart on this page). I then converted square meters to square feet (1 square meter = 10.7639 square feet) and used an estimate of 0.1 kg/square foot to get production capacity. That estimate of productive capacity/square foot is pretty commonly used and lines up pretty well with numbers reported by companies themselves in public reports (compare Table 1 and Table 2 here).

Licensed sales data also came from Health Canada. You can find links and details about computation in the Details and Data Sources section of my previous post.

The calculation for 2019 market size also came from Stats Canada data but required a little more leg work. It’s also far less precise than the numbers above because it requires estimations of black market sales, which are obviously more difficult to obtain.

I first took the three available quarters of data for 2019 for “non-medical (licensed)”, “non-medical (unlicensed)”, and “medical” cannabis from Stats Can’s report on detailed household final consumption expenditure and summed the three different categories to get the total cannabis market size. I then estimated the fourth quarter using an average of the three quarters available. This gave an estimate of $5.8 billion for the whole market. I then converted that to kilograms using Stats Can’s cannabis implicit price index, which told me that current overall price (which is a weighted average of illegal market, legal rec market and legal med market) are 78.2% of the 2012 baseline, which is $9.30/gram. That gives me a current price of $7.27/gram, which I used to find the market size in kilos of the 2019 Canadian cannabis market: 797,000 kg/year.

Major Take-Away: Canopy’s epic stand against a rapidly rising tide

In the four quarters since recreational cannabis was legalized in October 2018, the amount of cannabis sold in Canada (in kilograms, including both recreational and medical) has increased by 81%. Meanwhile, sales by the industry’s largest player have increased by only 8%.

Why It Matters: Market dominance is Canopy’s major appeal to investors

Canopy’s investor deck and financial reports heavily feature terms like “market leadership,” “driving the [global/medical/rec/retail/etc.] cannabis market” and even talk about “digging our economic moat.” They burned through 1.3 BILLION dollars in cash last quarter and are astonishingly unprofitable. The only plausible way to justify this is if they are investing in future profitability through the development of dominant market share and associated market power. In that context, bleeding market share isn’t likely to get voted the best look at the ball.

Moreover, management’s messaging around their most recent (and arguably catastrophic) quarter focused on the anemic roll-out of Ontario’s retail cannabis stores. Although the facts that Canopy is citing here are true (there is currently about 1 retail cannabis store for every 600,000 Ontario residents), the graph above calls into question those facts’ relevance. What makes Canopy think that stores opened in Ontario will help them sell more product? To date, the opening of retail stores has helped the Canadian cannabis market as a whole explode; yet it seems to have made precious little difference back home in Smith Falls.

Details and Data Sources

The information for kilos sold per quarter by Canopy comes from their quarterly reports (kilos sold and harvested can be found in the MD&A rather than the financials). Market size data comes from Stats Canada, which receives data directly from Health Canada. To be licensed as a legal participant in the cannabis market, you need to take part in seed-to-sale tracking and provide Health Canada with regular activity reports. As a result, cannabis market data (for the legal market, anyway) is far, far more accurate than estimates of other industries.

With that said, there are two caveats. First, at the time I am writing this, Stats Canada has not yet posted the sales data for September 2019 (the third of the three months that comprise Q3 2019) so I was forced to impute it. I did this by using the same growth rate from July 2019 (13,159 kg) to August 2019 (14,589 kg) for a growth rate of 11% and an estimated sales volume for September 2019 of 16,175 kg. It’s worth noting that the market share estimate that I came up with for Canopy sales using this methodology (25%) is the same as was cited by Canopy management during the investor call they held when they released their earnings for that quarter.

The second caveat concerns the equivalence between cannabis oil and dried cannabis. Stats Canada reports sales of dried cannabis separately from sales of cannabis oil. As a result, to get the scale of the cannabis market as a whole, you need to convert liters of oil to the kilograms of dried cannabis required to produce it. Each company in the industry has different processes and different inputs that they use for oil manufacturing, and so the conversion rate is not standard. Canopy’s stated conversion rate (found in their financial reports) is 5 mL/g (i.e. from one gram of dried cannabis they can manufacture five milliliters of cannabis oil). Others are higher, some north of 7 mL/g. I wanted a conservative estimate of the market (which makes Canopy’s market share bigger), so I went with a conversion rate of 7 mL/g. Regardless, the effects of changing this conversion rate are not substantial. A 5 mL/g conversion rate changes Canopy’s Q4 2018 market share from 42% to 40% and changes Q3 2019 market share from 25% to 24%. No matter the conversion rate, the basic and unflattering pattern in the graph above is unchanged.