Yep low grade fuel can produce smoke.
Oh and your right Sailor Steve my bad
but im pretty sure alot of the non warships still used coal though. Oil burning ships should have a fair amount less smoke then a coal burner, and diesel providing the engine is turned and not damaged (or using poorly refined fuel) should produce none at all (other then some white smoke in cold weather)
As for venting underwater, well the biggest issue is water pressure vs exaust pressure, plus the risk of the water backing up. Its also easier to do it verticaly and install safeguards that will stop water backflow, rather then horizontaly. Another thing they would do when surfacing and first firing up the engines im told is vent the exaust into the the ballast tanks which not only helped empty them, but also helped protect them from rusting due to the oil in the smoke when the engines are first started.