The oil on the water is probably coming from the oil/gas mix ratio your using for this motor through the exhaust, its not uncommon, most 2 strokes will oil up a little in the water barrel, what gas/oil ratio are you using? Is your water pump impeller old? If your not sure, replace it asap. Some of the pre/1960 motors had no pee hole so you need to make sure your water pump impeller is good and pumping water. you could probably tell by just feeling the engine block when it is running, if it gets super hot its probably not pumping water good. I had to pull the power head on one of my 50's OMC motors once to change the impeller, it was just designed like that. If you ask questions on this site you should probably list your engines model number also. Good Luck with it.