The next revolution in video games

July 25, 2012, 4:00 PM UTC

By John Patrick Pullen, contributor

FORTUNE — The fanboys are in a frenzy. The past month has been tumultuous for anybody trying to divine the future of video games thanks to hands-on sessions of Nintendo’s (NTDOY) Wii U fanning holiday launch rumors at the Electronic Entertainment Expo, an alleged two-year-old Microsoft memo leaking details of the next Xbox, and Sony acquiring the game-streaming company Gaikai. But the biggest force shaping the next consoles may not be amped processors or innovative controllers. It might be the cloud.

So-called cloud gaming involves a kind of apostasy. Typically, video game systems have gotten progressively more powerful. The more technical wizardry inside the box, the more fantastic the graphics displayed on-screen. (And the higher the price.) In contrast, cloud games are rendered by remote servers that beam images to screens over the Internet. This allows cloud gaming companies to operate much more like subscription services such as Netflix (NFLX). But there are considerable challenges: high quality graphics crush data pipes, and twitchy responses in fast-paced games can suffer because of network lag.

Over the past few years, several companies claimed to have cracked the problem. OnLive may be the highest profile company in the segment. It features a library of high-quality games as well as a still-unapproved but long-awaited app to play on Apple iOS devices. Otoy, known for remotely powering high-quality graphics for films like Avatar, has promised to release a cloud rendering platform which could be used for games. And Gaikai, which uses Java to stream high-quality games like Dead Island and Saints Row: The Third directly to web browsers, is being absorbed by Sony (SNE) in a $380 million deal announced July 2.

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The Gaikai acquisition, with its high price tag, has had industry observers wondering if cloud gaming’s time has finally arrived. “Having Sony acquire them is enormous validation of the space, in a way that now everybody is taking cloud gaming very seriously,” says Otoy founder and CEO, Jules Urbach. With Otoy’s purchase of New Zealand-based Refractive Software in March, and an undisclosed investment by Autodesk (ADSK) in 2011, the Los Angeles-based company is fashion content creation tools to help game developers optimize graphics for delivery via the cloud. The company’s game streaming platform is currently in closed beta.

There are hold outs though. According to David Dennis, senior group manager for Xbox, Microsoft (MSFT) does not believe that streaming has enough infrastructure to change the way games are played. “A model where someone is playing a AAA blockbuster game where there could be latency issues — and by the way, while they’re playing, they’re running up the meter on their broadband, adding huge, incremental costs on top of their standard broadband bill — is not an infrastructure or model that scales on a consistent global level,” says Dennis.

The company plan, for the foreseeable future, is to focus on online features that don’t require high-speed fiber connections. Streaming movies, music, and television; digital game distribution; and save game data are likely all that’s in store for Xbox Live’s 40 million users in the coming years. Dennis concedes that advances may come five years down the line. Until then, he thinks consoles will continue to crunch the data.

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An alleged memo from Microsoft that surfaced last month suggests the company has contemplated the alternative. The planning document which dated back to 2009 said streaming could be a major feature of Xbox by 2015. The memo also listed OnLive as a threat and a possible acquisition target with the potential to “up-end the console gaming market by making expensive consoles and PCs unnecessary for AAA gaming.” (Dennis declined to comment on the document’s authenticity.)

OnLive founder and CEO Steve Perlman also did little to deny the rumors. “Every kind of acquisition of every sort has been put on the table,” says the former Microsoft division president. “There’s no question that OnLive could go and fit together with a number of different company’s strategies.” But with a working product offering launch-day titles to an estimated tens of millions of users — not to mention the remote computing capabilities on its OnLive Desktop app — OnLive could haul in a much higher sum than Gaikai earned from Sony.

The current generation of hardware has become a $60 billion worldwide market, according to IDATE. But from 2010 to 2011, it grew a measly 0.4%, with online and social gaming providing most of the lift as traditional consoles declined. According to a recent study by the NPD Group, consumers in the U.S. spent $3.4 billion on video games in the first quarter 2012, and though physical content sales declined 5% against the same quarter 2011, digital content increased 10%. In that kind of climate, cloud gaming looks more viable.

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The irony? Though OnLive and others have slowly been building their businesses for years, Sony’s purchase of Gaikai instantly changed the dynamic. “Once someone’s thrown the gauntlet down and said, ‘We’re getting behind this thing,’ then the risk equation changes,” says Perlman. “It’s less about ‘let’s hope this doesn’t happen,’ and more about ‘let’s hope we don’t get left behind.'”