I suspect you are right.
This might be worth a surf on some xbox forums. I ignored all advice regarding towels. But mine did seem to last longer before it went like that if I stood it on its side...
that actually works temporarily
I have seen a number of references to towels on the xbox forums, but none saying what it is. Is this just blocking the vents to fry the thing?
will this guarantee the 3 flashing red rings that will prompt MS to fix it for free? :-?
The towel trick is to very seriously overheat the CPU and GPU (mounted near each other) in the hope that the thermal stresses will make contact again. Obviously, its never going to be permenent fix.
Its possible you could cook it enough to get the red ring, thus changed under warranty. Have you anything to lose?
As for standard repair costs, they can be bought brand new for under £100, complete with12 month warranty 
So if I understand this correctly, the thermal paste has ceased to function between the cooling and the chip (CPU, GPU) causing it to overtemp and exhibit the problems in the picture in the first post.
If this is correct, then isn't the best approach to buy a tube of thermal paste and renew this on the contact points?
or am I missing something?
Nope.
Both the processors are 1mm BGA items.
They are mounted on a cheap PCB which is poorly supported and then a heavy heatsink is clamped to them.
The result is stress on the solder ball contacts which, over time, start to fail.
So, the fundamental issues are;
1) Poor board layout
2) Cheap materials
3) Very poor mechanical practice.
Having the unit on its side will do two things
a) Improve natural convection cooling
b) Change the stresses on the solder joints caused by the chuffing great big heatsinks.
The towel trick just causes the poor thing to seriously over heat, this will do one or two things
1) It will stress the solder contacts (unlikely to get hot enough to reflow the solder though!)
2) VERY seriously stress the internal silicon (which will be many 10's of degrees hotter than the case temp)
3) DEFINATELY shorten the life of every other component on board!
If your lucky, it might give a temporary reprieve by making the solder blls make a physical contact for a while