In the muffler ??
I too am curious as to how you can see the oil in the waterlift muffler. You stated it is coming out the exhause into the water lift muffler. If you get 1/3 of a quart each time you run the engine, where is it going from there. If you get 1/3 of a quart into the muffler each time you run it, the muffler would soon be full if it doesn't discharge through the exhaust. Oil blowing out of the engine could be caused by many things, but I would tend to agree with Ross, and the first place I would look would be the head gasket. It has to be coming from someplace where it doesn't get into the combustion chamber or it would just burn and smoke. Depending on the engine design it could also be nothing more than a manifold bolt that goes into an oil passage and is a little loose.