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THANK YOU OP. You saved me from plenty of gray hairs. Though, I'll just note that I didn't have to disable UAC - simply starting Steam with admin rights fixed the issue.
Thank you mister...I discovered this after trying to run mods on Oblivion for two days. By the way...Borderlands 1 has a similar issue...you can not play online unless you run Steam as Admin.
I have found a temporary fix for this but I would still like to get Steam overlay working in oblivion if anyone can think of a fix. For now to play with mods I found a couple old links to an older obse_launcher.exe that seems to allow obse to work even without the steam overlay.
And just to be clear, steam overlay was not working for a clean install of oblivion with no mods or any tampering.