A technique is provided for processing well fluid downhole. The technique utilizes equipment for separating a well fluid downhole into a water component and an oil component. The separation of water and oil can be controlled by selecting an appropriately sized flow restrictor for use in limiting the flow of one or both of the water and the oil. Additionally, a sensor system is used to monitor a well characteristic that enables adjustment of the downhole fluid processing based on well characteristic data from the sensor system.