Cannabis: from black market to bull market

8 November is important, and not just because it is the date of the US presidential election. California is also voting again on whether to legalise cannabis – the measure was defeated by a 53% majority in 2010, but a lot has happened since then.

Legalise cannabis for recreational use

Colorado, Oregon, Washington and Alaska have legalised cannabis for recreational use. These are small population states and local government coffers are swelling. California is the most populous US state by a wide margin (38.8 million) and really needs the money. For example, the cost of pensions for state employees has jumped by 3,000% since 2000 because of silly crowd-pleasing decisions in the late 1990s that predicted markets always go up.

California was in fact the first to legalise medical marijuana use. Since then, Arizona, Connecticut, Washington DC, Delaware, Hawaii, Illinois, Maine, Maryland, Massachusetts, Michigan, Minnesota, Montana, Nevada, New Hampshire, New Jersey, New Mexico, New York, Ohio, Pennsylvania, Rhode Island, and Vermont have passed medical marijuana measures.

A yes vote would be a really big deal. It would create a market for the plant that would dwarf any of its neighbours. Additionally, if California gives the go ahead it is likely to represent the beginning of a trend where most other states quickly fall into line.

With legalisation comes investability, scale and industrialisation of the growing process. There are certainly efforts underway to create an appellation system similar to wine where small batch growers will be able to maintain a niche. But to be frank, that will do nothing to change the fact that with mass markets comes mass production.

That will mean lower prices. That’s a good thing: a more developed market means higher volumes, more competition, lower prices and less volatility. The experience with prices in Colorado certainly backs this up – a brief spike took place immediately following legalisation before crops matured and supply hit the market. Since then the price has fallen substantially at the wholesale level while retails prices are less susceptible to wild swings.

Marijuana Business Daily covered the price action.

According to data from the online wholesale marketplace Cannabase, the average monthly asking price per pound for recreational flower dropped to an average of $1,402 in June from $2,106 in January.

The lowest monthly asking price on the Denver-based site plunged even more, to $750 last month from $1,800 in January.

“We all knew it was coming, because more and more production capacity is coming online,” said Jay Czarkowski, an industry consultant at Boulder-based Canna Advisors. “Medical is hanging in there, but rec is really finally starting to plummet. I’ll use that word – ‘plummet.’ Probably 30% in the last four or five months.”

Average retail marijuana prices, by contrast, appear to have declined only slightly this year in Colorado. That’s good news for retail shops, particularly if they’re able to capitalize on the low wholesale prices and pocket the difference.”

The local vs the federal

The trend of states voting is for more relaxed or liberal laws, yet a staunchly conservative Federal government has created issues for related companies. For instance, it’s difficult to secure banking services, which has led to large quantities of cash that need to be warehoused. Since banks are federally regulated they have problems offering services to companies which obey local laws but are in a grey area when it comes to federal laws.

That’s why the Drug Enforcement Administration (DEA) is so important. It classifies cannabis as a “Schedule 1” narcotic with “no currently accepted medical use and a high potential for abuse”. Despite the fact two dozen states have concluded it does have medical uses, the government agency charged with classifying the dangers of narcotics has not yet been convinced.

But let’s not forget that government agencies are subject to political whim and bureaucrats know that better than anyone. The DEA would appear to be creating an opening for itself to change its mind without losing face. Last month the decision was taken to offer more licences to groups seeking to cultivate cannabis for research purposes.

Until now the University of Mississippi has been the only centre in the country with a licence to grow cannabis for research purposes. However, the purpose of the University of Mississippi programme (National Institute on Drug Abuse or NIDA) is to prove the dangers of the drug, not its medicinal value. Because they control supply, access to cannabis by labs doing different kinds of research has been limited. Offering the ability to cultivate different strains and in great quantities is a victory for researchers seeking to prove cannabis has a legitimate role to play in modern medicine.

Bureaucratic intransigence flies in the face of the everyday experience of hundreds of thousands of people taking cannabis for treating everything from post-traumatic stress disorder to migraines. Perhaps more important is that conventional drugs don’t work particularly well with these kinds of ailments, so the logical argument for further investigation into a product with such widespread anecdotal evidence of efficacy is hard to continue to deny.

UK and US-listed GW Pharmaceuticals is perhaps the best known of the companies developing cannabis-related therapies. It is targeting the epilepsy, oncology, multiple sclerosis spasticity, type 2 diabetes, schizophrenia and inflammation markets. The company has two products of its own in stage 3 trials and is in partnership with other companies on two more in stage 3 trials. Unsurprisingly, with such a rich pipeline it has become the subject of takeover offers. While the company reportedly has no desire to be bought out, it was announced on 7 September that it has hired Morgan Stanley to help field these inquiries.

The medicinal uses for cannabis are likely to be the catalyst used to get it over the line to legalisation and looser regulation which is already creating what some are calling a “Green Rush” in states with full legalisation. It’s a high-margin product right now and guess what: it grows like a weed.

Considering the publicity the market is getting following full legalisation in Colorado, the investment crowd is rapidly getting involved as it is a burgeoning opportunity for growth. Hedge fund clients of mine are opening touting their investments in growing operations. I know people who have leased prime farmland in California to aspiring farmers willing pay up to a year’s rent in advance.

These are important considerations because cultivation is a competitive business. Just like with any kind of farming, those with the cheapest cost of production will come to dominate the market.

Right now investors are looking at select areas of agricultural land or in desert cities where officials are willing to move mountains on the regulatory front to encourage greenhouse construction. However, with the eventual promise of full legalisation the potential for big tobacco or big alcohol companies to stake a claim to a substantial portion of the cannabis market is non-trivial. That would of course require that the market grow considerably from its current status, but that is looking increasingly likely.

This all spells opportunity to me. There are numerous ways of playing this kind of situation. I’m still deciding which is best – we want to marry the explosive short-term potential of this kind of situation with a focus on long-term returns. If you’re a Frontier Tech Investor reader, look out for next month’s issue. I hope to have a recommendation on this opportunity for you.

Category: Commodities

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