An additional difficulty would be that when using "foreign" languages, the game would have to check on the player's race: If I played a Khajiit, I'd understand their language, of course, and the dialogue would have to be spelt out in English. I might even argue that when playing a non-Imperial character, dialogues in my character's mother tongue would have to be in English, while cyrodiilic talk should be foreign and subtitled - to preserve the feeling that I people around me use a foreign language. And what if my character's mother tongue were Dunmeris (Dunmer talking English), he understood Cyrodiilic as a foreign language (represented by gibberish... I mean, a beautifully crafted artificial language
with subtitles), but had no idea of Argonian (different gibberish, without any subtitles)?
The game would fast become infinitely complex, just as the real world is. You have to make a cut somewhere to retain playability and accessibility, and for Oblivion, they apparently just decided that language was not a core concern of world creation.
It would be an option for dead langages like Ayleid, though.
There has to be some reason, other than it could get annoying for the player.
Why? An awful lot of things in a computer game are caused by technical limits, time and manpower constraints, simple money, or lots of other real world issues.
it would be no problem for them to invent a language, or base the game's language off of one that already exists.
To invent a language, is actually not that easy. Trust me.
And they'd have to do it several times over...
And honestly, I would find it quite unsettling if I bought the game and meet Nords there using German (my native language) or a butchered version of it. (Some movies did that - ridiculous.
)
Because the whole it could get annoying ideal, just doesn't seem to have a place in the lore.
It doesn't. It's basically the same reason, why the whole of Cyrodiil, according to the game, has a population of http://www.uesp.net/wiki/Oblivion:Demographics.