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The assets are squashed, but does the game actually renders at 640x240. It does some pixel effects like blending, shadows and I think some hue shifting (at least in AE), and those might be done at a higher resolution than the squashed assets.
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Actually it seems to be possible to render at larger resolutions. At least the game definitely accepts background files that are larger than 640x240. I've made a short mod for Oddysee a couple of years ago using Paul's editor and I remember that I used images twice as large as Oddysee default resolution and as far as I recall they actually displayed in better resolution in-game and I even had to size them down because they looked too sharp comparing to the sprites.