Cannabis-related stocks have racked up solid gains in the last year. Those increases have occurred despite the fact that companies from the sector are yet to report positive earnings. Investors are hoping that exuberant increases in the industry’s stocks, which regularly run into triple-digits, are reflected in its earnings. A key part of making those figures happen is federal legislation of cannabis.
Why Is Federal Legalization of Cannabis Important?
The United States is the largest market for cannabis. According to ArcView market research and BDS analytics, the country accounted for 90% of the $9.5 billion trade in cannabis in 2017. That dominance is expected to continue into the future as the cannabis market grows to $47.3 billion in 2027. The firms further state that recreational use of cannabis, which is more lucrative and easier to get into as compared to medical cannabis, is expected to drive future sales in the United States.
But cannabis is still classified under the Controlled Substances Act at the federal level, which means that its production and distribution for recreational use is prohibited by federal authorities. Tetrahydrocannabinol (THC), a psychoactive agent present in the cannabis plant, is mainly responsible for this classification.
Three Problems Due To Absence Of Federal Legalization
The most important problem for cannabis entrepreneurs is the lack of access to traditional funding sources for cannabis entrepreneurs. Banks refuse to lend to cannabis entrepreneurs due to federal legislation. While states have taken the lead in advancing legalization of cannabis, the absence of federal input magnifies the regulatory risk for cannabis entrepreneurs and inhibits the flow of investment capital into the industry. Even the Federal Drug Administration (FDA) has approved very few products containing cannabidiol (CBD), a non-psychoactive agent used in medicines from the same cannabis plant.
Typically, venture capitalists and private equity step in to provide funds to incipient industries. But they have been hesitant to enter the industry due to the social stigma attached to cannabis. (But that is changing).
For the most part, cannabis entrepreneurs have resorted to raising capital from family and friends for their ventures. Federal legalization of cannabis could unleash a flood of entrepreneurs interested in the space but unable to start businesses due to lack of funding. It could also kickstart a futures market for cannabis contracts in much the same way that there is a futures market for other agricultural commodities. Farmers cultivating cannabis could hedge risks by betting on futures contracts.
The absence of federal legalization also has the potential to cause supply issues by limiting the land under cultivation for cannabis. For any industry to grow, supply must match or exceed demand to grow the market. In the case of cannabis, the supply is constrained. This is because the Controlled Substances Act limits the amount of land that farmers can devote to its cultivation. Small businesses dominate the production of cannabis in urban areas in the United States while research into its medicinal uses drives the market for rural cultivation.
In contrast, the situation up north in Canada, where a relatively benign approach to cannabis is practiced, is different. Canada has become the biggest exporter of cannabis to the United States. Whilst local cannabis entrepreneurs in the United States mostly have small farms under cultivation, Canada’s Canopy Growth Corporation (CGC) has 4.3 million hectares under cultivation. According to reports, it also has more than a third of contracts in the country for recreational pot.
This leads us to the third fallout from the absence of a positive federal directive for cannabis. Prices vary wildly across states and are largely dependent on local economies. For example, cannabis prices have fallen dramatically in states that have legalized cannabis for recreational use, such as Washington and Oregon. The significant disparity in prices is bad for consumers as well as entrepreneurs because it limits the growth of the cannabis market by concentrating it in select states. The prohibition of interstate commerce for cannabis means that customers cannot carry cannabis between different jurisdictions and may be prosecuted per federal regulations if they are in possession of the drug. The effect is not limited to states. The size of operations for Canada’s Canopy Growth gives it the potential to implement economies of scale. This is reflected in pricing for cannabis products in the country: it is 30% cheaper to buy cannabis in Canada as compared to the United States.
The Bottom Line
The biggest effect of federal legalization would be the streamlining of the market for cannabis production in the United States. Currently, the market is dominated by small to mid-sized businesses who do not have the necessary access to funding or economies of scale to transform it with innovative products and branding. The latter is especially important if cannabis is to move beyond its negative federal classification to becoming a legally acceptable form of social recreation. U.S. companies interested in the markets have opted to list on Canada's stock exchanges, due to regulatory uncertainty in the United States. Federal legalization could throw the doors open for small businesses to pursue big ambitions or allow large multinational players with ample expertise and fund to enter the market. They could invest in research and marketing and, also, drive prices down.