explain "merging his essence with the entire palace"
No where in the manga such thing was mentioned. What was said is "he can fuse with any stone he touches"
Pica assimilates with rock, so he becomes one with the rocks. The castle is made of rocks, so he becomes one with the castle.
He should be able to feel everything that goes on in the castle. He doesn't need to have ridiculous observation haki.
No, No and No. Again, the palace is not Pica. However, Pica can control the palace that is why he slammed the walls on Luffy and Zoro. If he could feel like you said, why did he appear before them to slam the walls? Why didn't he sit in his office and slam the hallway on them? He has to be there to do whatever he wants to do. There is no way he will be in Point A and attack opponent X and at the same time attack opponent Y at Point B just because both enemies are in the palace. That is not possible.