Cannabis 2023: Moving Beyond the Pot Bust

The good news for the nascent U.S. cannabis industry is that its worst year ever is almost over. The bad news is that the cumulative toll of the ongoing deep slump in wholesale and retail weed prices is likely to keep mounting in 2023, amid an overdue shakeout of growers and retailers in the crowded sector.

Despite broad popular support for legalization, the companies catering to America's growing demand for legal marijuana under state laws failed again this year to end the federal prohibition of the drug. U.S. law subjects them to punitive taxes and business costs by classifying cannabis among the most dangerous and addictive illegal drugs. Weed's legislative prospects at the federal level in 2023 look hazy at best.

Meanwhile, the industry is paying the price for investment decisions that dramatically expanded supply after demand jumped during the early stages of the COVID-19 pandemic. "A lot of outlets for disposable income were closed, and the cannabis industry benefited," says Adam Koh, editorial director for Cannabis Benchmarks.

This year, with restaurant and travel spending back to normal, the growth in demand has tailed off, and even reversed in some of the most mature markets. Lower-income consumers have also seen high inflation slash their real disposable income. Amid the resulting supply glut, Cannabis Benchmarks' volume-weighted U.S. spot index for wholesale cannabis flower is down 27% in 2022. In Colorado, the average wholesale price is half of what it was a year ago.

Paying the Price for a Supply Glut

Retail investors who once looked to cannabis to make them rich would now in many cases settle for getting their money back. AdvisorShares Pure U.S. Cannabis ETF (MSOS), an actively managed fund focused on domestic multi-state operators, is down 72% in 2022. Two of the largest U.S. cannabis suppliers, Curaleaf (CURLF) and Cresco Labs (CRLBF), are down 57% and 73% this year. Both stocks trade on the over-the-counter market because U.S. law effectively bars domestic suppliers from the country's major stock exchanges.

Lower prices are slowly helping to curb supply. In California, where consumers can now buy an eighth of an ounce of high-grade cannabis flower for as little as $10, the wholesale price has wilted to less than $700 per pound. Some 60% of the pot farms in the Emerald Triangle, the traditional heartland of cannabis cultivation in northern California, have reportedly gone out of business since California legalized recreational use six years ago.

"Based on the price movement we've been seeing the last couple of months we are close to a bottom in wholesale prices," says Koh.

The pain, however, has already spread across the supply chain to cannabis retailers. In Michigan, the retail price of an ounce is down from $400 to $100 over the last two years. In Massachusetts, the retail price of a gram of cannabis flower buds has dropped below $8 from more than $14 early last year.

Julia Germaine, a Kind Ventures partner who helps manage the firm's portfolio companies including a Massachusetts cannabis delivery service, said consumer demand appeared to slow further earlier this month, reflected in the lower average value of orders as some customers cut back to afford holiday shopping. She expects a Massachusetts industry that still hasn't seen its "extinction-level event" to consolidate over the coming year as some of the weaker players cash out or fold.

This month, for the first time since Massachusetts adult-use sales launched in 2018, a pot retailer went out of business when The Source shut its doors in Northhampton. Elsewhere, the number of suppliers has already declined dramatically. In California's Monterey County, the number of cannabis industry workers plunged from 2,400 in July 2021 to 1,400 15 months later as 22 businesses closed. The county is now considering legalizing cannabis lounges to boost tax revenue.

Congress Refrain: Wait Till Next Year

With the supply/demand dynamics pointing to limited relief in terms of higher prices rather than a rapid recovery next year, cannabis companies and investors alike will once again look to Congress and the federal government to stop penalizing state-approved suppliers.

Prospects of help from Washington in 2023 receded, however, after the industry failed to secure the passage of the Secure and Fair Enforcement (SAFE) Banking Act, which would have given it access to banking services. In the absence of such federal sanction, banks and credit card networks have shunned state-approved cannabis, leaving it largely a cash business.

SAFE didn't make it into law this year because of opposition in the Senate. The narrow Republican House majority in the next Congress complicates the path for this limited relief measure and makes federal legalization in 2023 even more of a longshot.

Cannabis did score a win this year when President Joe Biden directed the departments of Justice and Health and Human Services to review pot's classification as a Schedule I drug under the Controlled Substances Act. "We classify marijuana at the same level as heroin—and more serious than fentanyl. It makes no sense," Biden tweeted.

The review could end federal treatment of state-approved cannabis suppliers as illegal traffickers, which prevents them from deducting business expenses on their federal tax returns. (The cost of goods sold remains deductible.)

Congress adopted Section 280E of the Internal Revenue Code in 1982, the year after a convicted cocaine trafficker asserted his right to deduct ordinary business expenses. The rule bars such deductions by traffickers in Schedule I and II drugs, including state-approved cannabis suppliers based on a subsequent interpretation by the Internal Revenue Service.

Under the Controlled Substances Act, the Biden Administration would have to consider pot's medical benefits and its potential for dependency and abuse before reclassifying it. The review is unlikely to be completed in 2023. With cannabis thought to drive elections turnout among voters who might otherwise stay home, additional measures easing the federal prohibition may stand a better chance in 2024.

Legalization Marches On

Cannabis continues to score successes at the state level, with Maryland and Missouri legalizing recreational use by referendum just last month. These states are expected to roll out retail sales next year alongside Connecticut, where they are set to launch on Jan. 10. New York, which will launch adult-use sales Dec. 29, will also see many legal stores opening next year.

Next up in 2023 could be Minnesota, Pennsylvania, and New Hampshire. In all, nearly half the U.S. population now lives in the 21 states that have legal sales. Millions more can easily and legally purchase the drug by crossing a state line.

This rolling wave of cannabis acceptance is backed by polls showing large majorities in favor of legalization. Consumption is up sharply as well, with 16% of Americans reporting they regularly use the drug, versus 7% in 2013. Only 11% say they use tobacco. What's more, polls show Americans view cannabis as much less harmful than tobacco or alcohol.

Given such attitudes, the spread of legal cannabis sales should, over time, continue to increase demand among consumers previously deterred by the prohibition.

In the short term, though, each time a state legalizes weed it releases another wave of private capital to build grow facilities and retail operations. While demand grows over time, the supply gains have been chunkier, because every time a state opens up to legal weed it triggers a rush by investors seeking first-mover advantages in the new market. Their greenhouses end up supplementing the supply from legal operators in other states as well as black market weed.

Meanwhile, most of the consumers of the new supply will likely be shifting from illegal sources. While the hangover in the wake of the COVID-19 binge is getting much of the blame for the market's current struggles, the expansion of legal supply as state after state has legalized the drug has also contributed to the downturn.

In the southwestern corner of Massachusetts near the borders with New York and Connecticut, the towns of Great Barrington and Sheffield, with a combined population of a little over 10,000, are now home to seven cannabis stores heavily dependent on out-of-state consumers. One of them, The Pass, is a regular advertiser on Radio Woodstock in Woodstock, N.Y. All will be hit by the imminent arrival of legal weed across the state lines.

The Bottom Line

Cannabis has never been so popular, or so cheap. Yet just over half of American adults have never even tried it, providing lots of room for future growth as that percentage shrinks.

Unfortunately for cannabis suppliers, too many of them have invested in this premise, leading to severe oversupply and a crash in prices. Many won't make it, but the winnowing is much further along in some markets than in others.

Congress and the federal government may eventually lift the federal prohibition that has cost the industry dearly. But that's unlikely in 2023.