Probably not an all or nothing answer to this but, when a mod says that it requires shivering isles installed does it mean:

1. Needs the oblivion.esm (SI) version
2. Needs the DLCShiveringIsles BSA files
3. Needs the loose files installed by Shivering Isles

For me, I do not plan to go to Shivering Isles, been there done that, so now focus on all the things I have not done in Tamriel. I would really like to get rid of any esp, loose file, or bsa I do not plan to use from the official installation.

So, will most mods that require shivering Isles work by only having the SI versin of Oblivion.esm? Or do I need the other files also? I guess a safe workaround would be to just unpack the bsa files to loose files but why add files if I do not need to.

It depends on the mod, but usually you will need at least the bsas and the esm. Simply because usually mods that require SI use assets from SI - without bsa these assets are not there and without the esm they're not added to the game. Not sure about loose files SI installs, no idea what files it installs other than bsa and altering Oblivion.esm (and the empty SI esp). Generally you can say that you will need a full SI install if you want to use mods that require SI.

The short answer is, (1) and (2) combined is probably the best answer, but it depends on what the mod(s) in question do.
For example, one of the mods I was involved in developing, WEPON, is dependent upon Shivering Isles. Much of the content is only accessible by actually going to Shivering Isles and interacting with its inhabitants; so the mod has a dependency on the various DLCShiveringIsles BSAs as well as the SI Oblivion master. Furthermore, the mod itself has DLCShiveringIsles.esp as a master, meaning it won't even load if that ESP is not present.

Other mods may only depend on the Shivering Isles BSAs. None would depend on the loose files (3), because as far as a mod is concerned there is no difference between BSA files and loose files.
Unfortunately, you wouldn't be able to save room by unpacking the BSAs into loose files, unless you know exactly which of those files are needed by the mod(s) in question.

EDIT: Ninjad!

Thanks for the answers. Short version is I need the files from the BSAs which I could probably get away with unpacking. The DLCShiveringIsles.esp is only used to load the BSA files so I would think a better technique for mods to check for SI would be the version of the Oblivion.esm, but I am not a modder so that may not be possible. When trying to save esp slots, every esp file is a target

BFG99, I use WEPON so if I go the no DLCShiverigIsles.esp I would assume I would need to change your plugin some way and that is WAY OVER MY HEAD. So I need to keep that and get rid of something else.