Doesn't matter if it's MPEG2, MJPEG or h264, there are some basic truisms about compression. Firstly, if the screen is mostly static or has slow motion, you can get away with absurdly low bandwidth.
It's quite a bit more complicated than what you're thinking, they haven't simple adapted an existing codec, they're written an entirely new codec, and redefined the logical constraints, to deal strictly with the issue of lag/response time. Specifically, they've loosened constraints on errors and failures, and added what sounds like very robust error correction, and they've thrown out the standard GOP method of encoding.
These are the guys who developed Quicktime back in the day, according to him he was the one who actually pushed Apple to develop a video codec at all, so he seems to brign some credibility.
Anyways, what he says is the basically threw out all the restrictions on the codec with regard to looking good when in a still frame, this codec is only dsigned to look in motion, i.e. you will only ever see this feed once: as you're playing. It's specifically designed to tolerate and expect errors, and has a whole bunch of code built in to hide or correct errors on the fly, and an active feedback loop to the server itself.
Then what they do is encode 2 streams of every playsession, the "Live" stream is lower quality, meant to be used only in action, but not for actual playback. It's also based on feedback from the client, and adapted on the fly. The 2nd stream is a highquality static stream which has no feedback loop, and would be used for playback, brag clips, or a multi-broadcast to many users, but not live play.
they had custom chips fabbed, and their sole purpose is to run their codec, this lets them get the per user hardware cost down to something like $30/person (initially the costs was around $10000/person using existing hardware), and literally encode a frame in 1ms.
Sounds pretty cool...also shows alot of faith in this codec, that they would go as far as to fab chips for it.
Again, I'm very skeptical as well, I don't think the quality is going to cut it, it just doesn't seem possible. But it's worth noting there's a whole lot more going on here than you are giving them credit for. They're not just compressing a bunch of h264 video and sending it out over the web, it sounds like they've done a lot of the nuts and bolts engineering that would be needed to really make something like this feasible. It's lightyears beyond MS's 'smooth streaming', though I'm sure they implement something along those lines as well (seems like it would be almost essential in a real world gaming scenario).