Cannabis prices are going to pot.

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As increasingly more marijuana growers entered the market and more states allowed residents to legally grow marijuana, cannabis prices dropped throughout 2016. Wholesale marijuana prices late in the year were roughly half the levels of 12 months earlier. Will this trend continue -- and possibly hurt leading marijuana stocks including Aphria (NASDAQOTH: APHQF),Aurora Cannabis (NASDAQOTH: ACBFF), Medical Marijuana,Inc.(NASDAQOTH: MJNA), and even GW Pharmaceuticals (NASDAQ: GWPH) in the process?

Image source: Getty Images.

So far, so good

Most marijuana stocks don't seem to have experienced any negative effects from falling cannabis prices so far. For some, the reason is simple: Cannabis prices haven't plunged in their markets.

Aphria and Aurora, for example, operate in Canada. The medical marijuana companies' stocks have more than quadrupled over the past 12 months. However, the dynamics of the Canadian market are quite different than in the U.S.

Canada allows use of medical marijuana but places restrictions on such usage. Patients must receive authorization by a healthcare practitioner to obtain marijuana for medical purposes. Canadians can grow limited amounts of marijuana for medical use, but any purchases must be made from licensed distributors such as Aphria and Aurora.

Medical Marijuana, Inc., however, does provide marijuana in the U.S., where cannabis prices have fallen. Nonetheless, the company's stock is up almost 400% in the last 12 months. Cannabis prices might be down in general, but Medical Marijuana's market size has grown even more thanks to more states legalizing marijuana.

You wouldn't expect GW Pharmaceuticals' stock price to be impacted one way or the other by wholesale marijuana prices. The biotech doesn't yet have a product on the market in the U.S. Positive clinical results for its experimental cannabinoid drug Epidiolex and anticipation of potential U.S. regulatory approval in the not-too-distant future, though, have caused GW Pharmaceuticals' shares to more than double over the last year.

Be afraid of the law?

Just because marijuana stocks haven't been impacted by falling marijuana prices yet doesn't mean they won't be affected at all. The law of supply and demand applies to cannabis just as it does to any other product.

The impressive performance of marijuana stocks has been made possible because of a rapidly expanding market. Legalization of marijuana in many states across the U.S. has driven demand higher. As growers jumped into the market to meet this demand, the wholesale price for cannabis came down -- just as the law of supply and demand dictates.

However, companies were still able to make a lot more money because of the increased volume. The higher earnings (and expected earnings potential) pushed marijuana stock prices upward.Can this continue indefinitely? Not for every stock.

Image source: Getty Images.

What will happen eventually is that demand won't grow as quickly as it has over the last year or so. With too many marijuana growers in the market, there could even be a glut at some point. If this happens, you can count on the prices of many marijuana stocks to fall. Some companies that are raking in the cash now could even go out of business.

This same scenario could play out in Canada as well. Over the next several months, the Canadian government will evaluate legalizing marijuana in the country. If this legalization occurs, we'll see the law of supply and demand work north of the border just like it does in the U.S.

What about biotechs like GW Pharmaceuticals that develop cannabinoid drugs? There's still a possibility that even GW could be impacted by falling cannabis prices. If the cost of cannabidiol (the active ingredient of Epidiolex) becomes low enough, it could potentially be cheaper for patients to buy from companies like Medical Marijuana instead of a prescription drug.

What's likely to happen

Marijuana prices probably won't drop in a steady fashion. There will be fluctuations, just as there are with any agricultural crop. However, prices will continue to fall if supply outstrips demand.

I don't think, however, that cannabis prices will drop enough to significantly impact GW Pharmaceuticals' prospects with Epidiolex. Assuming the company gains regulatory approval for the epilepsy drug and gets payers to cover it, patients will probably pay less out of pocket for Epidiolex than they would pay for cannabidiol products that didn't go through the Food and Drug Administration approval process.

The long-term fates of other marijuana stocks, including Aphria, Aurora Cannabis, and Medical Marijuana, will depend on how well the companies differentiate their products from others on the market. Falling prices indicate that marijuana is being commoditized. The best ways to compete in a commodity market are to innovate and differentiate. Smart investors looking to buy marijuana stocks will want to find ones that are already setting themselves apart from the crowd.

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