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:
- Increasing the Canadian population
- Increasing cannabis exports
- 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.