WHEN SUPPLY OUTWEIGHS DEMAND

BY CHRISTOPHER LYNCH

IN 2012, WASHINGTON and Colorado legalized the possession of small amounts of marijuana and also established regulation of commercial cannabis production, processing, and sale, as well as recreational adult-use. In response, the US Department of Justice (DOJ) announced updates to its marijuana enforcement policy.

US Deputy Attorney General James M. Cole issued a memorandum for internal use that set out enforcement priorities for those states that legalized cannabis activity or were considering doing so. In what is now known as the Cole Memo, the DOJ made clear that marijuana was a Schedule I drug under the federal Controlled Substances Act, but also stated that it would continue its traditional policy of relying on state and local governments to regulate this activity within their borders through enforcement of their own laws as they saw fit.

The Cole Memo stated that it would defer its right to challenge state laws allowing for the production, distribution, and possession of marijuana for the time being as long as the states established strict regulatory schemes to protect eight federal interests described in the memo. Among those eight interests was “preventing the diversion of marijuana from states where it is legal under state law in some form to other states.”

Diversion (the export of marijuana from legalized regulatory systems outside of that system) and the ability to regulate overproduction of cannabis remain some of the most difficult and predominant issues for legal cannabis to resolve.

Economic theory suggests that a commodity in a free market will reach an equilibrium price when supply and demand become equal. Theoretically, higher demand for a product decreases prices as more market participants become involved, whereas higher prices tend to reduce demand leading to an excess supply. However, the emerging cannabis industry is no ordinary market because of the strict regulation and oversight facing industry members, as well as the threat of federal prosecution.

Some law enforcement agencies argue that overproduction encourages producers to participate in the black market and undermines states’ recreational and medical cannabis regulatory schemes. Those agencies cite that overproduction of cannabis products and the subsequent decreased profitability result in a greater supply of product than the market demand and may result in diversion. The logic being that, rather than destroying excess product or letting it rot, some licensees may opt to illegally sell or transfer the product to consumers outside of the legalized regulatory system or to other states where commercial cannabis activity is still illegal. Based on the very distinct regulatory schemas of the states that have legalized commercial cannabis activity, however, it would appear that diversion may be a problem rooted in lack of oversight and enforcement rather than overproduction.

COLORADO

Colorado’s commercial cannabis market, though initially a target of both the federal government as well as neighboring states of Oklahoma and Nebraska for diversion issues, has reached a level of equilibrium. When Colorado legalized commercial cannabis in 2012 under Amendment 64, it set strict caps on the number of production licenses and amounts available to licensees. Colorado subsequently passed a bill in 2017, HB17-1220, directed at preventing diversion to illegal markets by placing a cap on the number of plants to be grown or possessed on a residential property, as well as establishing criminal penalties for violation.

In part due to this enforcement authority, it appears that Colorado’s supply and demand allowed adequate opportunity to equalize a fair market price of approximately six dollars per gram, according to BDS Analytics. Though Colorado certainly had its problems with diversion early in the inception of its commercial industry, it appears that enforcement and oversight in that state allowed the market to steady itself.

WASHINGTON

Washington is currently facing an overproduction problem, but it does not appear to have resulted in diversion, nor has it stopped the Washington market from normal market stabilization. Beginning in the summer of 2016, marijuana prices plunged as the market was over-saturated with product, and many businesses were concerned about market stability. Likely in response to the overproduction, the Washington State Liquor and Cannabis Board (WSLCB) began a period of enforcement focused on shutting down those businesses, licensed or otherwise, that engage in the diversion of cannabis outside of the regulated Washington system.

Despite the existing issues with the change to the LEAF traceability system in Washington, there does not appear to have been a documented increase in diversion, despite the wealth of product in the market. Much of this could be attributed to the increase in frequency of WSLCB inspections and the increased emphasis on enforcement as it relates to diversion. The WSLCB recently created and expanded the size of its special investigations unit, which is dedicated to complex issues such as diversion and hidden financial parties of interest.

On par with Colorado, market prices in Washington have dropped to an average of about six dollars per gram, according to BDS Analytics, and appear to be stabilizing. Though a surplus of product still exists in Washington at this time, it appears that Washington is moving towards equilibrium as the WSLCB increases enforcement efforts, companies fold, and the market struggles to self-regulate.

OREGON

Oregon presents a unique set of circumstances with regard to diversion and oversupply. In 2017, Oregon State Police released a study, “A Baseline Evaluation of Cannabis Enforcement Priorities in Oregon”, allegedly providing evidence connecting illegal external markets and in-state overproduction of marijuana. According to Oregon law enforcement, overproduction within the state encourages licensed producers to participate in the black market and undermines the state’s licensed market. Despite having a relatively low population compared to other states regulating recreational marijuana, Oregon has a diversion rate comparable to more densely populated states. The report argues that these figures constitute evidence that Oregon’s licensed production has been pushed “far beyond satiation of local demand.”

The issue of diversion in Oregon is well-documented. Oregon US Attorney, Billy Williams, an outspoken critic of the regulated cannabis market in Oregon, demanded reports and audits regarding overproduction and diversion in the state. As a result, in February of 2018, an audit of the Oregon Liquor Control Commission (OLCC) found that the state’s traceability system lacked proper safeguards and identified five major weaknesses in the tracking system implementation, which could facilitate or contribute to diversion.

According to the Oregon traceability system, there is currently a glut of more than one million pounds of usable, but unsold, marijuana in the state. This represents nearly three times the amount of cannabis that was sold in Oregon in all of 2017. Though the demand for cannabis in Oregon is expected to grow, it is highly unlikely that demand will increase quickly enough to deplete the reserves accumulated in Oregon.

The problem in Oregon is likely a lack of oversight. Since implementing its commercial regulatory system in 2015, more than 1,800 production operations have been licensed or are in various stages of approval. By way of comparison, Washington has 1,205 licensed cultivators of various canopy sizes with an estimated population of 7.53 million people. Oregon has a population of only 4.2 million, resulting in an inverse proportion of licensed cultivators to population.

Additionally, the Oregon Health Authority (OHA) completed a report regarding Oregon’s medical marijuana program operations and compliance in May of 2018, and confirmed the diversion issue. The OHA report links diversion to inadequate control and supervision by the Oregon cannabis regulatory bodies. The OHA further found that, despite more than 20,000 licensed medical grow sites, only 58 inspections were completed in 2017. The report states, “Potentially erroneous reporting coupled with low reporting compliance makes it difficult to accurately track how much product is in the medical system . . . this limits [our] ability to successfully identify and address potential diversion.”

Arguably, because Oregon’s cannabis industry is an evolving market, equilibrium is still a few years away. Unfortunately, given the broad-spread evidence of diversion and demonstrated lack of oversight, Oregon’s overproduction fosters a diversion problem.

CALIFORNIA

At this time, little information is available regarding issues of diversion in California, given the infancy of its regulated commercial market. However, the Bureau of Cannabis Control (BCC) included measures in their regulations to restrict licensees’ ability to divert product into the black market by including traceability requirements, security measures, mandatory video surveillance systems, and reconciliation of product on hand with the track-and- trace system every 14 days. Although the BCC has not expressly limited the number of cultivator licenses it plans to issue, it has allowed local jurisdictions the authority to determine the number of commercial cannabis licenses allowed in its own jurisdiction. It remains to be seen if California will have the same kind of diversion problems as Oregon or will find stasis as Colorado and Washington have. However, given that California has the sixth largest economy in the world and considering the state’s robust tourism industry, it is likely that the demand for commercial cannabis will avoid the same sort of oversupply problems found in other states.

Until cannabis is de-scheduled at the federal level, diversion will persist as an issue in the commercial cannabis market. By de-scheduling commercial cannabis activity at the federal level, the overproduction problem could be remedied by allowing those states with surplus to sell across borders to other legalized states, facilitating a larger economic market solution of supply and demand. Although the Cole Memo was rescinded by US Attorney General Sessions, states with legalized cannabis activity still have a vested interest in eliminating diversion. Those licensees that engage in diversion not only undermine the legitimacy of the industry as a whole, but risk federal prosecution as well.

Furthermore, because of federal illegality, legalized cannabis markets may not have the time or freedom to reach equilibrium in the way that other industries have. The threat of federal prosecution requires both licensees and licensing agencies to find a delicate balance between restricting the market to meet the guidance issued by the DOJ and allowing adequate time for a free market to develop and reach a sustainable and stable equilibrium.

Though overproduction of regulated cannabis may be a factor in the existing diversion issues, it seems clearer when comparing the various states that diversion is more closely tied to the effectiveness of regulation in that state. Those states that have demonstrated effective enforcement begin to see equilibrium of wholesale prices and demand, despite overproduction problems.

If you have any questions about the topics discussed here, please contact an attorney to discuss how these issues affect you or your business.

Newsletter

Sign up for our email newsletter!