After investigating the issue further, I have found that the game sometimes incorrectly detects your graphics card and sets everything to absolute minimum. The core of the problem lies in the fact that there are actually two places from which you can change graphical settings in Oblivion - from in-game options and from launcher. Regardless of how the game runs for you, try doing the following:
- Start the launcher
- Click Options
- Set graphics to "High" or "Ultra high" preset
If that helped, you may fiddle around with settings further and try to get acceptable performance. I could also look into which values you need to change in the .ini file.
You could try re-generating your LOD, altho what you're seeing does look like a bug.
To generate lod, use this tool. To ensure you read the readme (located in Docs folder after you download it), I'm not going to explain how exactly does it work, just reiterate: Make a backup! While it looks complicated, running it is actualy a matter of double-clicking an appropriate .bat file. As a bonus, if you are using any mods, they'll get incorporated into the lod.