There is no filter in this system and from your description it does have water in it. The Control Valve has stuck from your description and that is the problem, especially as the oil is like that.The oil needs changing when it is hot so it will drain all then crud out.Use Multi-grade 10W/30 oil, this will be a much better oil form your hydraulics to work in. The Valve sticking, remove the Right Side round plate and you will see the Control Fork from the Lever hanging down, with the engine idling, using a screw driver, move the fork back-wards and for-wards GENTLY Do Not Force it, once the Fork move so will the Valve.Now it is possible tat the Fork has become detached from the Fork. Stop the engine and follow the Fork down into the oil with your Hand, at the bottom, there is a short "bar" between the two legs of the Fork, make sure that it is attached to BOTH legs of the Fork, if it has come out, open the fork a little and fit the "bar" between the Fork Legs. If it is a slack fit, you will need to squeeze the fork legs together slightly to hold it in place. DO NOT PUT YOUR HANDS INTO THE OIL IF THE ENGINE IS RUNNING If you want all this written out for you with a bit more detail, email me direct and I will send it...John(UK)...firstname.lastname@example.org
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