News came out today that HEXO (NYSE: HEXO, TSE: HEXO), one of the largest licensed producers in Canada, is releasing a new budget cannabis brand costing consumers only $4.49 per gram.

HEXO is making waves as the first LP to offer dry flower at a price that competes with the black market.

According to Statistics Canada, illegal flower prices were $5.59 per gram through September, making the HEXO product a full 20% cheaper than the black market.

Even before this move by HEXO, cracks were beginning to show in the legal market.

Legal cannabis prices fell 4% through September, the first price decline since legalization.

We think this is just the beginning and HEXO has kicked off a cannabis price war in Canada.

Cannabis Prices: A Taste of Things to Come?

Source: StatsCan

First Comes an Oversupply

Let us explain using a lesson in supply and demand.

Say there are three flour mills, each with a pretty much identical bag of flour to sell, but there are only two bakers who need one bag each. This is what we call an oversupply. When there is more supply than demand, prices fall until the industry reaches a balance.

In this example the mills will now fight among themselves to lower prices until either the bakers buy all three bags of flour, or the highest cost mill goes bankrupt balancing the market at two bags supplied and two bags demanded. In either scenario prices fall as long as supply is higher than demand.

A similar situation is taking place in Canada as we speak.

Canadians are on pace to buy 150,000 kg of cannabis annually as of July. However the industry was already producing at least 260,000 kg through June according to our research and is building greenhouses with expected capacity of over 3 million kg’s annually.

Rising inventories of cannabis flower and oil backs up our view that supply is already exceeding demand.

Cannabis Inventories at 6 Months of Demand and Rising

Source: Health Canada

Falling Prices are Next

The first step of an oversupply is too much cannabis, what comes next will be a war on prices.

HEXO has already thrown the first stone.

HEXO’s Original Stash brand is priced 60% below the average legal price of $10.23 per gram and has already been followed in Ontario by at least two new low-cost strains selling for $5.59 and $6.50 respectively.

Every other producer and province will follow.

Source: OCS.CA

Licensed producers are now between a rock and a hard place.

With way more supply than demand, LPs will have to compete against each other and the black market on price if they want to sell all this cannabis.

According to a government survey, only 34% of consumers would be willing to pay a $5.00 premium over the black market for legal cannabis.

Today we estimate the legal market share is even lower, at 20% based on 750,000 kg of demand in Canada.

The only hope Canada has to balance supply and demand in the near term is to thoroughly crush the black market, and that will be accomplished through price.

If they don’t, inventories will continue to pile up and greenhouses will sit unused.

Falling prices should cause consumers to jump for joy, but for the cannabis investor, more tough times could be ahead.