Several methods have been used to measure the interface between water (typically on the bottom) and oil in a separator or other vessel. Differential pressure measurement is possible, but the ranges are very small. Capacitance just doesn't seem to work.
The "emulsion" layer that forms between the water and oil in a vessel proves especially difficult to measure.
There are two companies that I know of that use "microwave absorption" technology for level measurement. By far, the better known is Agar Corporation. They typically use two probes, one as a control (or alarm) and the other for measurement. These probes measure the amount of absorption along their length. This translates to PERCENT water.
By knowing the position of the probe, the level can be deduced. This works great with the emulsion layer, and can tell the operator exactly how large that layer is.
A typical system runs around $25K, including engineering, commissioning, and training (last time I checked - over 5 years ago).
I don't work for the company, in fact, I have nothing to do with oil any more (I'm in the gas industry). This is a product that isn't well-known, however, and one that can solve a lot of headaches.