The combustion efficiency and pollutant emissions are key issues for the study of diesel engine combustion. The remarkable effect of water on the reduction of pollutants has been confirmed previously, while other problems, such as whether oil consumption can be decreased and the overall effect of water on combustion performance are still not very clear. In the present paper, a detailed analysis for the effect of water in oil has been conducted and the results show that: (1) compared with oil without water, the stronger entrainment ability of water-blended oil, leading to more complete combustion and more rapid heat release, is one of the main reasons for decreasing oil consumption; (2) because of the production of steam from water in oil, the pressure in chamber will be increased and the engine power output may be improved, which will partly overcome the disadvantages of heat absorption by water vaporization and contribute to oil consumption economy; (3) although more latent heat of water vapor may be lost in the exhaust with the increase of the amount of water in oil, the temperature in the chamber will be depressed also and the total enthalpy loss is less, again decreasing oil consumption. Furthermore, there is an optimal water content to lead to a maximal power output.