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You are here: Home / Cannabis Price Risk Management: Part 1 - The Basics

Cannabis Price Risk Management: Part 1 - The Basics

Posted by Kris Lenz on Aug 17, 2021 10:38:29 AM
Kris Lenz

At its root, the cannabis industry is a commodity business. And like all commodities, producers and retailers find themselves at the mercy of trends in wholesale pricing that they have little to no direct control over. For example, as a cultivator you may build your entire operation around a cost per gram that ensures a profit at the end of your production cycle. But if the cost per gram suddenly drops, due to market saturation or a downturn in demand, you may find yourself in the red despite executing your business plan perfectly.

In mainstream industries, there are well-known hedging practices based around price risk management. Hedging against price risk simply means strategically deploying financial, purchasing, and/or market strategies to mitigate the risk of negative price movement. You’re essentially taking out insurance against price volatility to lessen the impact of adverse trends.

As a relatively young industry, price risk management is a comparatively new concept in the cannabis and hemp sector. Transactional volumes remain highest in larger geographies with multiple buyers and sellers, relatively stable regulations, and little vertical integration. Even with higher volumes traded, prices have continued to move in unpredictable ways, creating wholesale price uncertainty for buyers, sellers, and the ancillary businesses whose products and services support the primary market participants.

Price uncertainty, regarding both today’s prices and those in the future, creates risk for individual businesses, as well as in the overall economics of this sector. As legal cannabis markets expand, and rules and regulations evolve, so too will those elements required to underpin a robust transaction, hedging, and risk management market.

Additionally, the establishment of new state-legal cannabis systems has accelerated recently, creating new markets where supply, demand, and price dynamics are uncertain and will continue to evolve for some time. Looking further, but hopefully not too far ahead, federal legalization of the cannabis industry and allowances for interstate commerce will introduce a whole new layer of uncertainty in cannabis prices. 

GreenGrowth CPAs has partnered with Cannabis Benchmarks a leading provider of financial, business and industry to develop this guide demonstrating the fundamentals and value of price risk management. Cannabis Benchmarks has been reporting on wholesale cannabis prices and markets since 2015 and have supported an increasing number of inquiries regarding “hedging,” or the management of market price risk. 

In this article, the first of a three-part series, we examine the potential and basics of cannabis price risk management, including:

  • What is hedging?
  • How can buyers and sellers of cannabis benefit from hedging?

Market Price Risk and the Basics of Hedging

Managing the exposure to market price uncertainty is a critical requirement for growing businesses, and that need is most apparent in several key activities:

  • Cost and margin management: Buyers facing uncertain wholesale markets seek stability in their cost base, margins, and cash flows.
  • Revenue management: Sellers also contend with uncertain revenues that impact margins and cash flows.
  • Growth planning: Decisions regarding where to expand and what type of facilities to build are directly affected by expected future prices and are undermined by substantial uncertainty.
  • Third-party funding: Capital providers rely heavily on forecasted revenues that are extremely sensitive to wholesale market fluctuations.

There are multiple possible supply chains in the cannabis industry, and some simple examples are shown below.  Here, each arrow represents a flow of physical cannabis product and, for each of these, there is a corresponding flow of money in the reverse direction.

Cannabis supply chain

All of the participants shown here could have significant exposure to market price volatility and reasons for seeking to stabilize or manage that uncertainty.

Volatility as a Measure of Uncertainty

One very common way to measure the level of price uncertainty for any commodity is “volatility.” This metric provides a measurement of how much prices would be expected to change over an entire year, on average, and can be expressed as percentage change in prices. Measures of volatility do not indicate direction of price change, but provide an indication of the magnitude of price swings.

The graph below compares the actual measured price volatility of selected cannabis markets with other (predominantly) agricultural products during the 2020 calendar year. The green bars are the Cannabis Benchmarks Spot Indices for the U.S. and the major western markets. The blue bars are commonly traded non-cannabis commodities.

In analyzing the chart below, several key observations emerge. For 2020, cannabis price volatility in the most mature markets was similar to other established agricultural commodity sectors; while energy markets – natural gas (NG) and crude oil (WTI) – were the most volatile of all major global commodity markets.

Cannabis Price Volatility

[Volatilities are calculated as the annualized standard deviation of the log price changes over the historical period.]

Volatility is typically greater in new and emerging markets like cannabis, compared to more established markets, since the latter tend to have a greater number of participants, higher trading volumes, and better-defined rules and venues for trading. Market price volatility can be troublesome for all the participants in the value chain. Traditional supply and demand elements, such as weather, drive many agricultural markets, however significant price movement in cannabis markets appears to still be driven largely by regulatory decisions - a trend unlikely to change in the short term. New commodity markets typically begin as “physical transaction only” markets which tend to be fragmented across regions and quality levels. Eventually, buyers or sellers begin to look for transaction agreements that cover a series of deliveries over some forward period, ranging from months to years.

Understanding the Benefits of Forward Markets

Forward deals or contracts are agreements between buyers and sellers to deliver a certain amount of a specific type of product at some point or points in the future. One example would be for a series of bi-weekly deliveries over the next 6 months, all at the same fixed, agreed-upon price. Such arrangements can be advantageous to both buyers and sellers. Buyers gain consistency in their expenditures, as well as a predictable supply of product of known characteristics, rather than scouring the market ad-hoc to replenish depleted inventory. Sellers gain from Forward contracts by securing regular revenue, in addition to the knowledge that the product will be moved and will not require storage and upkeep for an indeterminate amount of time while it is shopped around.

Forward Prices 

Expectations regarding prices for future deliveries are typically shown in what is called a forward curve to facilitate longer term transactions. Cannabis Benchmarks produces an Implied Forward Curve that reflects six-months of forward benchmark price assessments. This curve summarizes the price buyers are agreeing to, or willing to, pay cultivators for delivery at a date in the future (payments made at delivery). The graph below shows the monthly average for the U.S. Spot Index from July 2020 through July 2021, appended with the six-month Implied Forward Curve, reflecting the market’s expectations for wholesale prices through January 2022.

Predicting cannabis prices

Many market participants armed with an understanding of forward prices and seasonal pricing trends can employ forward deals to their advantage, using a variety of contract structures to manage their exposure to different spot and forward prices.

Cash Markets and Forward Markets 

It is important to make the clear distinction between the cash markets and forward markets, to understand how price risk management tools are used. The cash market refers to the current physical goods market. These transactions take place at specific locations and are immediately settled, so that the cash and the commodity are exchanged concurrently. The majority of current cannabis transactions occur in the cash market.

The forward markets include all transactions and pricing that are agreed to now, for delivery and payment in the future. These take the form of a legal agreement between two parties to buy or to sell an asset at a specified future time at a price agreed upon today. The details of this usually private, unregulated agreement can be customized between the parties. 

Market price uncertainty can only be managed in the forward market, since the very nature of the cash market involves the spot commodity price. But forward market agreements require the parties to transact at a specified price. Typically, there are two general types of forward price specifications: fixed and indexed.  

Fixed prices specify a particular absolute price, such as $1,400/lb, whereas indexed prices specify a particular index or benchmark that will be known or settled only in the future.  An example of an indexed price specification might be: “price paid is equal to the Cannabis Benchmarks Oregon Spot Index for the week of delivery, plus $25/lb.” Note that the fixed pricing eliminates price uncertainty while the indexed pricing retains some price uncertainty. By using a combination of fixed and indexed pricing agreements, cannabis market participants can manage market price risk in a way that best suits their particular needs. 

Coming up next...

Stay tuned for Part 2 of this series, where we will explore the current state of the cannabis markets and identify opportunities to utilize price risk management strategies.

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About Cannabis Benchmarks

Cannabis Benchmarks®, a division of New Leaf Data Services, is a leading provider of financial, business, and industry data and intelligence for the North American cannabis markets. As an independent, unbiased wholesale Price Reporting Agency and the creator of the world’s first Spot & Forward benchmark price assessments for U.S. and Canada's legal markets, Cannabis Benchmarks® has quickly become the trusted source for delivering information that allows market participants to make informed business decisions with confidence.

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