Cannabis Industry Rollouts: Lessons Learned from States’ Experiences
Bart Schaneman from MJ Business Daily recently released, “2020 Cultivation Snapshot: U.S. Wholesale Marijuana Prices & Supply.” The information contained in the report helped cement certain insights I’ve had about the evolution of the cannabis market.
In addition to the myriad other laws and regulations, all states essentially have two basic requirements:
- Transportation: Transportation between licensed suppliers (Growers, Processors, Testing Labs, Retailers) must be carried out by licensed Distributors
- Lab Testing: All cannabis products must pass Lab Testing before being sold by Retailers
There are thus two possible paths to market (see Figure 1):
- Flower: 1 → 2A, if pass testing regulations, then → 3A → 4A
- Everything Else: 1 → 2B → 3B → 3B, if pass testing regulations, then → 5B → 6B
States’ experiences with the roll-out of cannabis markets have essentially shown that these markets have behaved just as basic economic theory would have predicted.
Market stability is all about balancing Supply and Demand
Market stability is all about balancing supply and demand. The essential players in a retail game generally include (i) companies involved in making the product (Growers or Manufacturers), (ii) companies involved in selling the product to customers (Retailers), and (iii) Customers themselves (see Figure 2). The cannabis market is no different. Behind the scenes in cannabis, Processors, Distributors, and Testing Labs also play key roles on the supply side (see Figure 1).
In their rollouts of legalized cannabis markets, states have generally experienced some combination of:
- Testing bottlenecks (not enough Testing Labs)
- Distribution bottlenecks (not enough Distributors)
- Long lines (too few Dispensaries)
- No lines (not enough Customers with access)
- Empty shelves (too few Growers, Testing Labs, or Distributors)
- Lack of shelf space (too many Growers or too few Dispensaries)
- Price crashes (too many Growers or too few Dispensaries)
- Price spikes (too few growers, Testing Labs, or Distributors)
Examples from Mr. Schaneman’s report include:
- California: “One reason product is scarce: A lot of cultivators in the region have gone out of business because there aren’t enough outlets to sell into, and prices on the wholesale market were too low.”
- Colorado: “Similar to other recreational cannabis programs such as Oregon and Washington state, the wholesale flower prices in Colorado started strong when sales began, then hit bottom after production ramped up and flooded the market.”
- Illinois: “Wholesale marijuana flower prices in Illinois are soaring as strong demand in the state’s nascent recreational cannabis program puts a strain on supply and cultivators scramble to build out facilities."
- Massachusetts: “As regulators gradually add more marijuana retail stores, supply could become even further strained before production facilities are built out to full capacity and catch up to the appetite for adult-use products.”
- Michigan: “... strict testing standards are causing a bottleneck in the supply chain ...”
- Oregon: “Oregon regulators set a low barrier of entry to grow cannabis in the state, and steady overproduction drove the market to rock-bottom lows.”
- Washington: “... the state faced oversupply challenges for several years and wholesale flower prices were once some of the lowest in the country ...”
These problems are all due to imbalances in supply and demand. The fact that there have been supply chain imbalances is not surprising. After all, legal cannabis markets have accelerated from 0 to 120 (redlining it in many places) in a short period of time, where every piece in the supply chain has had to be established from scratch, or close to it.
You also have a lot of players in the game who are operating independently of one another. In that case, market mechanisms and incentives have to be well-designed, indeed, to yield coordinated outcomes among the separate players. Not a dance for the feint of heart. And extremely difficult to achieve in regulated markets that feature an abundance of constantly changing license requirements, regulations, and taxes at each segment along the supply chain.
A big problem with market misalignments is that they’re not fixed with surgical precision. Rather, they involve overshooting the target. So rather than having shortages in supply being increased just until supply equals demand, you get overshooting of production. So shortages are followed by gluts, which are then followed by shortages, and so on. Hopefully, the overshooting becomes less and less each period, but it generally takes some time to achieve balance.
Cannabis has taken the same path as that in all other new markets
New markets with large market potential all tend to follow the same path: A frenzy of suppliers enter the new market, creating a wild west in supply. Massive investments are made. There is a frenzy of activity. Many businesses go bankrupt. The market consolidates, where stronger and/or better-financed players buy up assets from bankrupt companies, generally for pennies on the dollar. Businesses that remain serving as the backbone of the industry are larger, stronger, and more vertically integrated than the original new entrants.
This same pattern has played out in cellular telecom, computer hardware, computer OS, as well as in each segment of internet businesses: social media, search, ecommerce, music, etc. Currently, the same cycle is playing out in autonomous vehicles, electric cars, electronic medical records, blockchain, AI, and IoT, just to name a few.
Type and extent of regulations will determine market structure
In regulated industries, the type and extent of regulations tend to determine market structure. Generally speaking, the greater or more extensive the regulations are, the fewer and more integrated the eventual suppliers will be.
In cannabis, limits on numbers of licenses issued, large licensing fees, high tax rates, and extensive and dynamic regulations make it costly and difficult for suppliers to enter the industry, and they cause imbalances in the supply chain. In these cases, unless restrictions prevent it, suppliers will either horizontally or vertically integrate, so as to either decrease costs and/or ensure stability in supply.
Horizontal integration (Figure 3) can achieve the following:
- Help Growers achieve leverage with Retailers, such as enabling Growers to negotiate higher prices for Growers or better access to Retailers’ shelf space.
- Help Retailers achieve leverage with Growers, such as enabling Retailers to negotiate lower prices for Growers, higher prices for access to Retailers’ shelf space, or Retailer guarantees of access to Growers’ product.
- Help, respectively, Growers and Retailers each scale, thereby spreading costs of laws and regulations over larger numbers of units sold.
- Help, respectively, Growers and Retailers each focus on exploiting economies of specialization.
Vertical integration (Figure 4) can achieve the following:
- Ensure Growers better access to Retailers’ shelf space.
- Ensure Retailers better access to Growers’ products.
- Help Growers and Retailers better endure market instabilities.
- Help Growers and Retailers jointly scale, thereby spreading costs of laws and regulations over larger numbers of units sold.
Examples from Mr. Schaneman’s report include:
- Colorado: “A rash of acquisitions last year left a large swath of business in the hands of a few bigger vertically integrated businesses that can absorb market variations.”
- Massachusetts: “When prices are this strong, vertically integrated companies have an advantage if they sell their own flower exclusively at retail or produce enough to sell into the wholesale market.”
- Nevada: “Vertically integrated companies locking down shelf space and holding it for their own products”
It appears that vertical integration has become the more prevalent short-term solution for managing instabilities in the supply-chain associated with rolling out completely new industries. This makes sense, since the initial priority is getting product to market.
Later however, after markets mature somewhat and supply chains have stabilized, I predict companies will spin off whole divisions and specialize in particular segments of the supply chain. The cannabis supply chain is complex (see Figure 5): there are many different products and processes involved at each stage of the value chain. And each stage of the chain is positively mushrooming with new knowledge and technologies to improve products and processes (for an analysis of cannabis patents, see “Trends in Cannabis Patents over Time”).
As the depth of knowledge and expertise continue to grow, I predict that many companies will narrow their focus and specialize in specific segments. Of course, some companies will continue to span seed-to-sale operations, but I predict they will become the exception, rather than the norm.
Excessive taxes and regulations feed black markets
Arguably, the largest hurdle for states to overcome in establishing functional legal markets in cannabis is the large, well-established, black market in cannabis. The black market makes it exceedingly difficult for regulated industries to successfully lure suppliers and customers away from black markets and into legal markets. By their very nature, regulated industries involve costly regulations. Since black markets, by definition, don’t abide by legal market rules, they don’t incur the same costs of regulation that legal market actors must endure. Black markets thus offer lower prices than those in legal markets. And since (i) price savings in the black market increase with regulations, and (ii) cannabis markets are highly taxed and regulated, it follows that legal cannabis markets must compete with much lower prices in black markets.
For regulated markets to thrive, regulators must either moderate taxes and regulations to ease the burden on legal market players or increase enforcement of black market activity. CA has raised tax rates while also considering lowering them. California and other states, such as Massachusetts, have also made some effort to arrest black market suppliers.
Examples from Mr. Schaneman’s report include:
"... an arduous tax burdens cultivators to the tune of $800 per pound of wholesale flower.
This drives some legal companies out of the market, giving illicit businesses a competitive advantage and pushing the need for licensed companies to vertically integrate to succeed."
"However, growers report some significant challenges persist, including:
• Taxes are too high. Flower is taxed at about $150 regardless of the price it fetches on the market, which cuts into profits.
• The illicit market continues to thrive, both in the cultivation and retail sectors."
Until regulators do a better job of minimizing black market competition to help legal market suppliers not just survive, but actually thrive, long-term survival of legal markets in cannabis will remain unstable.
 John Schroyer, “California marijuana taxes will increase New Year’s Day”
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