The Canadian cannabis market is mired in a massive supply glut. It really comes down to three key reasons:

  1. Black market continues to reign supreme.
  2. Nobody wants the mid-tier cannabis flower produced by the mega licensed producers.
  3.  Vapes and edibles haven’t been available to consumers.

Canada has 250 days of oil inventory and 150 days of flower inventory as of August — this is incredibly high.

Source: Health Canada

Cannabis Extraction Companies are Not Immune

Cannabis extraction stocks, MediPharms Labs (TSE: LABS) and Valens GroWorks (CNSX: VGW) have been a haven of relative strength in a challenged macro supply/demand environment.

Grizzle’s Cannabis Extraction Guide provides a solid overview of the sector — risks and opportunities.  At that time our view was that there was more risk to the downside than upside for the sub-sector for three key reasons:

  1. Throughput volume wouldn’t materialize
  2. Current high operating margins would compress
  3. Limited technological barriers to entry for competitors

CURRENT, LIKELY AND POSSIBLE PROCESSING CAPACITY

Source: SEDAR Filings, Grizzle Estimates, StatsCan, Health Canada

Cannabis is a commodity. No matter where a company sits on the supply chain it’s not immune to the supply/demand dynamics of the underlying commodity (which in the case for cannabis is uniformly ugly).

Royal Dutch Shell is an excellent example of how commodity stocks trade. The time to sell commodity stocks are when operating margins are high (market is euphoric) and the time to buy them is when operating margins are at their worst (blood on the street).

Shell Stock Price vs. Operating Margins

Source: YCharts

You can neither bet that vapes and edibles will save the sector nor that extraction companies will be able to preserve their excess margins.

Cannabis extraction companies in our view will certainly follow this tried tested commodity trading pattern.

It’s one thing if demand for legal product was high but that simply isn’t the case. To make a big bet that vapes and edibles will save the sector and that extraction companies will be able to preserve their excess margins is an assumption too far.

 

Trade Extraction Stocks around Earnings

It’s interesting to see the trading pattern of MediPharm Labs (TSE: LABS) around earnings releases for the last 3 quarters. Like clockwork the stock has sold-off relative to the broader cannabis benchmark Horizons Marijuana Life Sciences ETF (TSE: HMMJ).

The following hedged strategy has yielded an impressive 190% return over the last 7 months:

  1. A day before earnings release go short LABS and long HMMJ
  2. A month before the earnings release go long LABS and short HMMJ

At best these extraction stocks are likely dead money until investors get excited a month before next quarterly earnings, better to wait for the prize then (don’t tie up your capital now).

Source: YCharts