What cannabis shortage? Analyst warns oversupply could become a problem in mere months

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In Alberta, a moratorium on new cannabis retail store licences was just lifted. In Quebec, government-run pot stores have returned to normal hours. In Ontario, there are rumblings that a second tranche of retail licences may be on the way, perhaps as soon as the end of the month.

These incremental but significant signs are leading a growing number of analysts and industry observers to speculate that Canada’s cannabis shortage, a problem that has plagued the industry since legalization, may be coming to an end. Some are even starting to contemplate an entirely new problem that could emerge, as early as next year.

“I’m forecasting an oversupply in dried cannabis by January 2020,” said Chris Damas, an industry analyst who authors The BCMI Cannabis Report and has spent years documenting the growth of the domestic cannabis industry.

Based on an analysis of reported harvests of 18 of the biggest licensed producers in the country, Damas has calculated that 76,112 kilograms of dried cannabis were produced in the first quarter of 2019. He projects that by the fourth quarter, this number will soar to almost 150,000 kg. It is just an estimate, because some licensed producers, for example Cronos Group, do not reveal production numbers.

By his calculations, that’s enough to supply 617 retail stores with an average of 20 kilograms of dried cannabis a week. But, he says, the number of stores that will be approved and operational by the beginning of Q4 will be 400 at most.

“There will be appreciable excess saleable dried cannabis in the market by Q3. There will not be enough extraction lab capacity to absorb this excess dried cannabis, which will have to be stored or destroyed,” he said.

Damas is not the only analyst who is starting to consider the ramifications of an oversupplied cannabis industry.

A recent Scotiabank report, written by cannabis analyst Oliver Rowe, reached a similar conclusion, albeit with a slightly longer time horizon. ”Announced domestic capacity from Canopy, Aphria and Aurora alone is enough to supply our estimated legal market,” Rowe wrote, forecasting an oversupply scenario in the “medium to long term.”

“Based on published data for February 2019, the aggregate run-rate annual production for the LPs is almost 220 tonnes. This is not a theoretical production number, based on what producers say they can do; rather, it is based on what they have already done. Based on a recent tour of several production facilities, we think this figure is substantially understated.”

In 2018, legal demand for medical and recreational cannabis was approximately 63,000 kilograms, according to the Scotiabank report, which relied on official Health Canada and Statistics Canada data. The bank forecasts that demand could quadruple to 259,000 kilograms by the end of 2019, based on the assumption that a substantial portion of the illegal demand turns legal.

As long as you have an undersupplied market, which we have right now in Canada, it is very hard to evaluate market strategy because you’re selling all you can produce

Paul Rosen, CEO, cannabis investment firm Tilray Royalty Corp.

Rowe noted that producers his team have spoken to were “generally aware that the industry will eventually be oversupplied” but held a degree of “complacency” since few believe that they will be the ones unable to sell their product.

“I’m not worried about it,” said Cam Battley, chief corporate officer of Aurora Cannabis, when asked about a potential oversupply scenario during a recent interview with the Financial Post. “Thus far, it has not played out that way so we’ll see. We’re completely sanguine of what will happen in that eventuality.”

Meanwhile, licensed producers’ inventories are piling up in an almost-exponential fashion. In March this year, just 7,627 kilograms of dried cannabis were sold in the legal market, but total inventory reached a staggering 143,773 kilograms. The biggest unknown, of course, is how much of that inventory licensed producers are hoarding to turn into edibles and concentrates, which are set to become legal this October.

Battley was vague when pressed on this question. “We will allocate product for edibles and concentrates over the next few quarters so that we can be ready to launch,” he said. “As you heard me say on the earnings call, our business is going to prioritize vape pens and edibles and that’s based on our research of consumer demand in the U.S.”

The dilemma for LPs is figuring out consumer preferences when edibles and concentrates become legal, and allocating product accordingly, said Paul Rosen, managing partner at Breakwater Venture Capital, a cannabis-focused investment firm.

“As long as you have an undersupplied market, which we have right now in Canada, it is very hard to evaluate market strategy because you’re selling all you can produce,” he told the Financial Post recently. “What I will say is, when that equilibrium changes, I have no doubt that many cannabis companies will die. There are too many small producers that are going to run out of liquidity and go insolvent.”

As it stands, Canopy and Aurora have a dominant position in the domestic market, capturing more than 50 per cent of recreational sales. There are well over 100 licensed producers in Canada — Damas’ calculation of an eventual oversupply only takes into account a scenario in which fewer than 20 licensed producers reach full production.

“Many of these smaller companies that have gotten licences have not even begun growing; they are still out there looking for capital,” Rosen said. “And then you have the big guys scaling up quickly, with inventories surging.”

There is some optimism, however, that the oversupply and subsequent price compression scenario that both Rowe and Damas are predicting will never come to pass.

Many smaller companies that have gotten licences have not even begun growing. And then you have the big guys scaling up quickly, with inventories surging.

Paul Rosen, CEO, cannabis investment firm Tilray Royalty Corp

Longtime cannabis analyst Graeme Kreindler from Eight Capital, a boutique investment firm that is heavily involved in the capital markets side of the cannabis industry, says the cannabis shortage will carry on for most of 2019, and even into early 2020. “We estimate a need for 807,000 kilograms of cannabis in 2019 to satisfy demand in both medical and recreational markets,” Kriendler wrote in a recent report.

“But we expect just under 600,000 kilograms of capacity will be available to the market in 2019, based on estimated inventory balances across LPs, as well as projected construction timelines.”

Damas stands by his research and his sources. He says a cannabis retailer in Alberta told him that the Alberta Gaming, Liquor and Cannabis agency (AGLC) is giving retailers almost double the cannabis per week than before. “He told me (he) got around 20 kilograms last couple of weeks, and it had been in the low tens for most of the year,” Damas said.

“The data is undeniable — knowing their expansion plans, knowing their funding, knowing what they can and cannot do, by January, we are going to be swimming in dried cannabis biomass.”

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