(FORTUNE Magazine) – Here's an interesting recipe for making wine. First, find a region whose climate is at the extreme limits for viticulture so that each vintage becomes a roll of the dice. Next, plant mainly black grapes even though you aim to make mainly white wine. Create friction by ensuring that the grape growers are not, by and large, the people who make the wine. Tie up vast amounts of capital by making blended wines that require huge reserves from past vintages to maintain consistency of style. Finally, limit the permitted vine-bearing land so that one day it will be impossible to grow enough grapes to satisfy ever-increasing demand.

Lunatic as it sounds, that's champagne. "It's a tough business," says Bruno Paillard, who rolled the dice 20 years ago to create his own prestige champagne house from scratch. "You need to be a bit crazy to make champagne." So why did Paillard leave a secure life as a wine broker for the uncertainty of making champagne? Why has a hardheaded investor like Bernard Arnault of luxury-goods conglomerate LVMH collected a host of grandes marques like Moet & Chandon and Dom Perignon to become the largest producer in the business--paying $175 million for Krug a few years back, even though the legendary vintner was reputedly not making a dime? And why are more and more grape growers, who used to sell their harvest to the large champagne makers, now producing wine themselves?

The answer has everything to do with what American real estate agents call location and what French winemakers call terroir--the complex interaction of soil, microclimate, topography, and other factors that make a wine-producing region unique. The Champagne region's terroir requires extra effort from man and vine alike, but the namesake vintage that results is the world's benchmark for sparkling wine. "There's only one place you can make champagne, and it's right here," says Paillard, as he weaves his ancient Peugeot sports car through Rheims on the way to his winery on the outskirts of town. "We are what every other sparkling wine can never be."

What's more, Champagne's terroir is in short supply. Strict rules dating from 1927 limit the amount of land entitled to grow grapes for champagne to some 270 villages in the region around Rheims, 80 miles northeast of Paris. Almost all of that land--the appellation contro-lee--is already planted with vines. Add on regulations restricting the grape yield per acre and juice yield from the grapes, and it's clear that Champagne is very close to its production limit of about 300 million bottles a year. Global demand will soon bump up against that total, so unless the rules are relaxed--or the region's graveyards are converted into vineyards, as the Champenois often joke--producers will soon find themselves on the right side of a demand-supply equation. A century ago London's Hotel Savoy was charging 12 shillings for a bottle of 1893 Charles Heidsieck champagne, a shilling more than a Chateau Mouton-Rothschild Bordeaux of the same vintage. Could a top champagne, which now fetches half as much as a comparable Bordeaux, once again price itself alongside the best reds?

For the moment the Champenois have more immediate cause for celebration: The harvest is safely in, and in cellars from Rheims to Epernay, all the indications are that this will be a vintage year. The optimism is in stark contrast to the gloom of a year ago as the industry nursed a millennium hangover. Convinced that the world would greet the year 2000 by drinking copious amounts of champagne, the Champenois dug into their reserves and shipped a record 327 million bottles in 1999, compared with the previous year's 292 million, itself a record. Sales indeed surged, but not enough: Millions of bottles went unsold. Then, along came a global economic slowdown. In Britain, the largest export market, sales plummeted from 32 million bottles in 1999 to 20 million in 2000; in the U.S., from 23.7 million to 19.2 million. Overall, shipments in 2000 fell 22.6%, to 253 million bottles, prompting the Champenois to say the sky was falling.

It wasn't. Though disappointing, sales in 2000 were not far short of the 1996 total of 256 million bottles, which was hailed as a banner year. In the meantime the price producers were getting had risen 26% over the same period. Things got even better in 2001, despite the post-Sept. 11 air travel slump that grounded so many champagne-swilling business passengers. Thanks to a 22% rebound in Britain and strong demand in France, shipments reached 262.6 million bottles, worth $3 billion. This year promises to be even better: In the first seven months overall shipments increased 16% and exports rose 24% over the previous year.

Remy Cointreau, after a difficult fiscal year ended March 31 that saw sales of champagnes and wines slide 20%, is predicting a 30% sales increase this year as the U.S. pipeline refills. And thanks mainly to strong sales of champagne and other spirits, LVMH posted a 19% increase in operating profits, to $756 million, for the first half of 2002, despite continued weakness in fashion and leather goods. "We've gone from bust to boom," says Yves Benard, head of the champagne arm of LVMH and co-president of the CIVC, the champagne trade association. "Now we must guard against getting carried away."

Renewed demand and the looming production ceiling may be good news in theory, pointing to a seller's market and rising prices. But in practice many champagne producers could find themselves squeezed if higher production costs (read scarcer grapes at higher prices) cannot be passed on to consumers because of competition from other sparkling wines. Back when Europe's demimonde was drinking champagne out of slippers at Maxim's restaurant in Paris, champagne could command top prices. But then it had few rivals. Now, low-cost, mainly New World sparkling wines (some of which have usurped the champagne name in defiance of world trade rules) enjoy a 12-to-1 lead by volume over the French original--and their quality is improving dramatically.

Against this backdrop, champagne's future begins to look a little less rose. Price increases probably won't dent sales of the cuvees de prestige like Moet & Chandon's Dom Perignon or Perrier-Jouet's Belle Epoque. More uncertain, however, is the outlook for the basic, blended, nonvintage champagnes that are the mainstay of the business. Competition from other forms of fizz, Benard concedes, will make it difficult for those champagnes to hike their prices, raising questions about the ability of the industry as a whole to grow its bottom line if it cannot increase volume. Small wonder that many of the top producers, including Roederer and Moet & Chandon, have hedged their bets and now make sparkling wine as far afield as Argentina and Australia.

Champagne also faces a squeeze in its own backyard. To the outside world, champagne is synonymous with the flagship labels that sustain its luxury image. Indeed, the top ten marques account for 30% of total sales and more than half of exports. But the big houses are negociants--they purchase from others most of the grapes and bulk wine they need to make champagne. They own just 10% of the vineyards. The rest is divided among some 19,000 independent growers. Most growers sell their grapes either directly to the negociants or to the big cooperatives that act as middlemen. But more and more are making their own champagne to capture the value added in the finished product. "I sell half my harvest to the negociants and make my own champagne with the rest," says Philippe Feneuil, president of the growers' main association. "But I'd be better off keeping all my grapes."

Given the precarious supply outlook, predatory times may be ahead. "Restructuring in the champagne industry is inevitable," warns Dominique Heriard Dubreuil, chairwoman and CEO of Remy Cointreau, whose champagne brands include the prestigious Charles Heidsieck marque as well as the younger Piper version. A sign of the times came earlier this year when LVMH sold its underperforming Pommery marque to rival Vranken--but held on to Pommery's 121 acres of vineyards. "Everybody's scrambling to secure supplies for the next ten years," says Feneuil.

Champagne's 46 cooperatives are also making their own champagne, as well as store-brand champagnes for Europe's supermarkets, where price often takes precedence over quality. Alain Rouchaud, managing director of Remy Cointreau's champagne division, worries that these producers may do little to nurture champagne's global reputation. "Poor quality and a sell-at-any-price mentality," he says, "do not help the champagne image."

With the harvest now over, the Champenois' favorite parlor game will soon begin: arguing whether to solve the supply problem by extending the appellation. Unfortunately, as Feneuil explains, this is not a quick fix. First, the growers will have to debate the issue. Even if they decide to go ahead--not a foregone conclusion, given the jealousies likely to be aroused by conferring Champagne status (and prices!) on new land--it will take the INAO (the Paris-based organization in charge of regulating the French appellations controlees) about five years to set extended boundaries. Add in planting time, and Feneuil reckons it will be 2015 before any new vineyards can come onstream--if at all.

"Champagne's salvation," says Feneuil, "does not lie in expanding the appellation. We've got to do better with what we have." He believes it's time to play the quality card to keep champagne competitive in the sparkling-wine market, even as supply-side constraints put upward pressure on prices. Paillard is of like mind. "In the long run we can't compete on price, so we have to compete with what's in the bottle," he says. Terroir will always be champagne's trump card, but the quality lobby reckons that more could be done to help nature, focusing on quality over quantity. "We worry about how much champagne we can make," says Paillard. "Instead we should be making less and making it better."

Technology is part of Paillard's answer to improving quality while cutting costs. In his state-of-the-art winery, sophisticated climate controls obviate the need for underground storage, and gyropalettes holding 420 bottles each have replaced armies of riddlers--the workers who laboriously hand-turn each bottle of maturing champagne to concentrate and remove sediment. Paillard is also pickier about his grapes. He uses only the best juice, which comes from the first pressing, to make his wines, although the rules allow for two pressings. "Some see this as a waste," he says, "but for me it's fundamental to ensuring quality wine."

Anselme Selosse, a second-generation grower-producer, outwardly couldn't be more unlike Paillard. The latter is urbane and cosmopolitan; Selosse is a hands-on grower. His artisanal winery, sitting atop a warren of ancient cellars in the little village of Avize, is in stark contrast to Paillard's revolutionary glass-and-steel winery. But like Paillard's, Selosse's dedication to quality and terroir ensures that his wines are sought after. He is part of a band of growers who believe that well-tended vineyards will repay the effort by producing great champagne. "I see myself more as a winegrower than a winemaker," says Selosse. "If you have quality vines it's not hard to make quality wine." The CIVC is also campaigning for more environment-friendly viticulture, warning it could withhold the champagne appellation from those who don't shape up.

But if quality is the name of the game, then some say it's time the rules were updated so that the flagship marques that sustain champagne's reputation can distinguish themselves from their lowlier cousins. At present all champagnes are lumped together by the one-size-fits-all appellation. Many producers are wary of meddling with that simple system. But Tom Stevenson, author of the authoritative annual Champagne & Sparkling Wine Guide, argues that champagne is overdue for a "completely new raft of a dozen or so hierarchical appellations" that would help consumers by more accurately reflecting a particular wine's quality and provenance. Basic nonvintage blended wines, for example, could still be sold as champagne, but wines benefiting from more rigorous grape selection and longer aging would qualify for superior status.

"There are all sorts of measures we can take to ensure champagne keeps its reputation," says Paillard. "And when you produce wine in such a difficult region you also need some luck." Paillard knows all about that. On Sept. 11 last year, he and his top American customers were due to meet for a tasting at the World Trade Center in New York. But the gathering was scheduled for late morning, so they avoided the death and destruction of that day. "A lucky break," says Paillard. It was a grim reminder of just how precarious life can be, and a reason for wine lovers to hope that Paillard's--and champagne's--luck holds. After all, we need the stuff to celebrate our own lucky breaks.