Step 1: A simple test for placing only is to ask what exactly is being restricted, in this sentence it is the drink itself, water, and nothing besides it.
Step 2: Rule out Drinks alone water first, since alone is not grammatically used this way. Then compare Only drinks water, which wrongly suggests drinking is the only activity he does, against the two remaining options.
Step 3: Placing only right before the word it limits is the standard rule, so Drinks only water reads most naturally and states clearly that water is the sole thing he drinks.
\[\boxed{\text{Drinks only water}}\]