The water makes a sludge mix with the oil and any airborne debris (dust etc.) that comes with the compressed air. Then, when this sludge dries out between tool uses, the result might actually prevent the tool from working at all the next time you go to use it.
Hint: If the tool will not work when you are supplying enough air at the correct air pressure to run it (do please check these first) then sometimes a gentle tapping of the tool housing with a hammer might loosen up the vanes and allow the tool to run again. If this occurs, then once it’s working again, flood the inside of the tool with lubricating oil through the air connection, and run it into a bucket until all the oil has blown through. This may clean it sufficiently to allow it to run again next time you want to use it. Failing that, it’s time to take the tool to the shop for a stripping and cleaning, if you are not up to doing that yourself.
A few home compressed-air users may have built devices for their home or garage that use air valves and air cylinders to make them work.
Water flowing down with the compressed air will act negatively on both the air valves and the air cylinders.
With manual air valves the sticking can be overcome by exerting a bit more force on the valve handle.
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