Graphics becomes very unimportant after a minimum level has been reached. That level depends highly on the game world interface as well as the personal preferences of the gamer. This minimum level is clearly higher for a 360 degree first person world exploration type of game such as oblivion than it is for a top-down dungeon hack game such as Nethack. Seeing a lot of '@'s walking around in the Imperial City would most likely feel kind of wrong, allthough the thought is somewhat fun to contemplate
However, quest branching & interconnectivity, in depth conversation and conversation branching coupled with more intelligent NPC conversation (better AI or more heavily scripted conversations) as well as the option for different quest solutions add a lot of "reality feeling" to the game. Your character's impact on the world becomes more tangible. The processing and memory cost for these things are so small that they would have no impact on game performance in a game such as Oblivion. However, they do demand some in the creativity department as opposed to graphics which is "simply" linear algebra and lots and lots of computations.
Also, a more or less linear game with non-linear quests, such as Arcanum, is by far preferable to a non-linear game with linear quests, such as Oblivion. Please note that I'm NOT comparing 3rd person view to 1st person view or graphics. Rather, imagine Arcanum quest implementation in an Oblivion environment!
Conversation
Bethesda boasts (check the game demo video) about how their NPCs are almost not scripted at all, but are controlled by AI along with each NPC having a set of goals. While a good AI is certainly not trivial to develop, heavier scripting or longer AI development time could avoid silly conversations such as:
A: Hi
B: Hi
A: Any news from the other provinces
B: Nothing I'd like to talk about
A: Bye
B: Bye
[Less than a second passes...]
A: Hi
B: Hi. Have you heard about... <insert news from some other province here>
Conversation is also in many aspects completely disjoint from actual in game events. For example *spoiler*
NPCs will continue to refer to Traven as being alive and in command of the guild after he is dead and you assume the role of Guild Master.
Conversation branching could be much approved. Options to go down evil, good, cowardly, boastful or other conversational avenues would improve the in character feeling (which is virtually non existent).
Conversation impact would be another nice feature, though I imagine it would take a whole load of work to achieve a sufficient level. But, imagine conversation options (dependent on the speechcraft skill) that you would use to, hopefully, improve the NPC's reaction to your character rather than the quite silly disc rotation approach.
Quests
Quest interconnectivity is another way to improve the feeling that your character has a true impact on the development of the game world. Often it doesn't even need a high level of creativity to achieve this.
Consider a simple thing such as *spoiler*
When you get to the part in the DB quest line where you're supposed to kill the retired officer, you might be given an option to strike a deal with him to fake his death and cut off his finger as proof you completed it, IF you have gained his trust earlier on by ginving him two witnesses to incarcerate the corrupt officer in the Imperial City. This in turn could then lead you to brgining down the entire DB instead of becoming it's leader
Quest branching giving you the oppertunity to make personal choices on how to solve them adds a role playing element (the important part which in my book is what makes a game an RPG: see the RPG general discussion forum for my view on that) and gives a nice foundation for getting "in character". Add in the possibility of different solutions based on your actual character build and things are starting to look very nice indeed.
A very simple and maybe somewhat silly example... Let's say you're asked to put a stop to a corrupt officer of the guard.
1) You have a high speechcraft skill (character build option enables this) and are able to persuade/fool the head of the imperial guard to
1a) outright kill the corrupt officer (pure player choice, in character acting; evil/chaotic solution)
1b) drag him before a magistrate (lawful solition) where you once again use your speechcraft skill (as dialogue options) to
1b-a) have him hanged (vengeful approach)
1b-b) have him pay restitution to his victims then be sent to hard prison
labor (the goody-two-shoe way of doing things)
2) You have a high marksman skill allowing you to
2a) Use blunt arrows to knock the corrupt officer and his shady contact
unconscious at a crime scene where the guards will find them...
2b) Kill an innocent from an angle that makes it look like it was the corrupt
officer who did the deed...
If this is coupled with quest interconnectivity things can quickly become rather complex. Perhaps one or more of these solutions open up, or closes down, other quests or possible quest solutions. It also adds a lot to the atmosphere and your character becomes more real.
Game World Impact
A lot can be done in this department as well. Let's just say I was very disappointed when the second Necromancer I encounter, far from the first I found, actually attacks me when I walk up to him peacefully without sneaking wearing a full necromancer garb...
Considering the success of the TES series, Bethesda ought to be in a position where they could put considerable effort into these things. While they obviously don't create games out of charity, I'd gladly take the aforementioned improvements at a trade off in worse graphics or a higher retail price. As things stand, Oblivion is nothing more than a Zelda II (The Adventures of Link for the NES) in 3D.