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This article will not cover any individual stocks at all. I have seen at least 7 or 8 fanboy articles, on Seeking Alpha, over the last month or so related to the burgeoning Cannabis industry. Although I may agree with and support the idea of legalization from a social stand point, that is very different to saying it is a good investment right now. In this article, I will try to provide some balance to the reefer madness currently sweeping Wall St. I will go nowhere near the usual arguments of legislation and the taxation issues that are typically thrown out there by opponents. Instead I would like to take an honest look at the industry as it exists in the United States, including issues surrounding sustainability.

Confessions of a Pot Farmer

Yesterday, I had the opportunity to sit down and converse with a retiring pot farmer for several hours. Bob was not a sixty something hippy, perhaps in his early forties. He did not walk up and introduce himself saying "Hi, I'm Bob the pot farmer from Humboldt." We had been talking for some time before that revelation. I decided that this was the perfect opportunity to get a few questions answered as he seemed willing to talk about it.

Bob had apparently spent the last month or so winding down his business affairs and was now ready to move on to the next stage in his life. Given the current enthusiasm surrounding the Cannabis industry, I found the timing of this a little odd. It just begged the question;

"Why are you retiring just when pot appears to be gaining acceptance and going legal?"

To be honest I was expecting an answer along the lines of over regulation, government intervention, taxation or shrinking margins. I was surprised that the answer I got included none of these things.

In 1996, California legalized the use of medical marijuana. Prior to that point, The Emerald Triangle, Humboldt, Mendocino and Trinity counties, was the Wild West of the US cannabis industry. The growers were frequently raided by government agencies and were hiding out in the rugged hills of Northern California. The growers were not all Hippies, after the collapse of the logging industry almost everyone was growing pot.

Since legalization, they have been able to come out from the shadows, and many of them now supply dispensaries. They pay taxes and as much as 80% of the local economy can be attributed to marijuana production. California produces 40% of the pot in the USA, the majority of which is produced in The Emerald Triangle.

Marijuana is California's largest cash crop at around $14 billion per year. Production costs average $400-$500 per pound and that wholesales for around $2000, a nice margin. Some growers have expressed concern that wider adoption of legalized marijuana could hurt margins, but the majority realizes that volume increase will more than compensate. This is where Bob's decision starts to make sense for him.

The industry is changing, no more hand trimming; there are machines to do that now. The need to produce more is putting pressure on the growers. More plants more headaches, it's just that simple. The growers used to be just average Joes filling a demand. In recent years it has become much more "gangster," people driving around in huge SUVs guzzling gasoline and more concerned with appearance than anything else. It is not the same industry he got into, but does that make it a bad investment?

No.

The Real Issues

Inefficiency is the first place to start. Almost all of the marijuana consumed in the United States is grown indoors. With wider adoption of legalization this may change, but currently it has been estimated that 75 gallons of gas are used in the production of 1 pound of pot. Can you imagine growing potatoes like that? Not only does growing take a lot of energy it also consumes a massive amount of water.

According to Bob, California is at the start of a 100 year drought, there is just not enough water. I told him that I had heard California was going through a dry spell. With another reference to the gangsters, he told me about an elementary school that had had its entire water supply siphoned off by pot growers.

"When they are stealing water from school kids, that's just not an environment I want to be near."

Now, these seem like some outlandish claims, surely we would have heard something about this on the news. Bob was very sincere when he talked about all this and I decided to give him the benefit of the doubt. If any of these things had happened, or were happening, it should be fairly easy to fact check. So in the interest of some sort of journalistic integrity, here is what I found.

"Bridgeville Elementary School was reopened Wednesday after being forced to close for a day when staff discovered up to 20,000 gallons of water had been stolen from an onsite water tank during the Labor Day weekend."

Catherine Wong/The Times-Standard (Eureka CA) 09/05/2013

In the same Article we discover that this is also not an isolated case.

"The theft comes one month after 20,000 gallons of water were stolen from the Weott Community Services District Board, which provides water to a community of 330 people -- including Agnes J. Johnson Elementary School, the Cal Fire station, the post office and a state park campground."

There really is no indication of who may be to blame for all of this until the very end of the article. According to Humboldt County Sheriff's Office, Lt. Steve Knight,

the crimes do not seem to be connected, but they raise concerns of potential water wars in Humboldt County due to significant marijuana cultivation in the area.

"Just last week, we made arrests for stream diversions at a marijuana grow," he said. "We may see more of that if the weather stays like this."

I guess that part of the story checks out, so how bad is the drought? When Bob talked about a 100 year drought, I was thinking along the lines of a 100 year flood. A onetime event which, although severe, only happens every hundred years or so. I soon discovered this was not what he meant at all. According to an OpEd in The Los Angeles Times yesterday, this is the driest year in half a millennia.

"Although one extremely dry year is a major hardship for a state with 38 million people and a $44.7-billion-a-year agricultural industry, this year is also coming on the heels of a decade of relatively dry years. Since 2007, we have had six below-normal years, this year being by far the lowest. It is a reasonable question to wonder whether our state is in the midst of a prolonged drought.

Tree rings, lake and ocean sediments, and other earth materials provide natural archives that reveal our region's climate history. And the history of the Western United States is one apparently plagued with deep and prolonged droughts on a fairly regular basis. Multi-year droughts have recurred every 20 to 70 years over the last several thousand years, related to changes in ocean temperature in the North Pacific.

How long can these multi-year droughts last? In the modern historic record, they lasted only six years: from 1928 to 1934 and from 1987 to 1992. But the climate archives going further back reveal that droughts often lasted much longer than a decade, causing large lakes to shrink or dry up completely, more frequent wildfires and native populations to embark on massive migrations. A particularly dry stretch occurred between AD 900 and 1400 (during the Medieval Warm Period), with two 100-year droughts in California and the Southwest. Throughout the Southwest, archaeological remains show that flourishing civilizations all but disappeared as their agricultural bases withered."

(B. Lynn Ingram is a professor of earth and planetary science at UC Berkeley; Frances Malamud-Roam is a senior environmental planner and biologist at Caltrans)

I suggest you read the rest of the article, there is good evidence to suggest that Bob's 100 year long drought is not as crazy as it first seems. Interestingly, the LA Times released this article the same day I was talking to him, so I don't think this could have been the source of his information. I wish I had asked him where he heard it.

Sustainability?

It would be reasonable to assume that if Marijuana was legalized at the Federal level, it would be regulated by the ATF and FDA. Almost every state that has legalized medical marijuana has included a clause allowing patients to grow their own limited quantities. I can find no reason that either the ATF or FDA would overrule this precedent. For example, is growing a few plants for recreational use any different than being a home brewer? The plant is nicknamed weed for a reason, it is very easy to grow. There will always be people who prefer to purchase, but wide spread home production would obviously put pressure on industry margins.

If the regulation is stricter, then we will see the tobacco companies getting involved. If the drought in California proves to be short, we may see a boutique trade form. Similar to the posh winery tours that exist there now in the Napa valley, The Emerald Triangle may carve out its own niche. That may be all that is left of the industry in its current form.

Conclusion

There still appear to be too many unknowns to instill any confidence at the moment. There is no guarantee that the companies currently involved in marijuana production will still be around in 5 years. A prolonged drought in California would cause some real issues for the industry. Even another two or three years with below average rainfall will cause serious issues. If we are anywhere near 10 years then California has more to worry about than pot. A drought of that length would have serious implications for the entire US economy. A drought in excess of a decade could lead to the largest human migration in the USA since the Dust Bowl. When you add the complication of legislation and taxation, the battle looks a little more uphill. Many of these issues will take time to resolve and I can see no reason to be rushing into this space right now. There will be plenty of opportunity in the future once the path becomes a little clearer. Although the public face of the industry appears to be above board we cannot ignore the supply side issues. I find it ironic that the growers are not getting arrested for cultivation, instead they are in trouble for stealing water. Until that element works its way out of the supply chain, I have no intention of getting involved. To put it simply I echo Bob's thoughts.

"I will not support or invest in any industry that steals water from school kids."

Source: Cannabis Investment: The Grass Ain't Green, It's Brown