I came across USBoot a few days ago and decided to give it a try today. I see that jaclaz had suggested it in a few previous posts way back in the mists of time.
I used a freshly installed netbook with XP SP3 (no updates added) as the 'source', a 2GB USB NTFS flash drive as the 'target' and followed phase-i, ii and iii.
I have written up my result into Tutorial 105 here (as usual).
What I have now is a flat file Windows XP USB drive which I can boot on most systems. No internal hard disk is required by this install of XP, so you can boot full XP on a system containing just the USB flash drive. Performance is not that bad considering either!
P.S. You will need to disable Standby as you cannot wake it from Standby.
I had several attempts at using a VM to generate the image without success though...