I believe that it might come from smoking opium. It definitely refers to the sort of daydream you have whilst smoking a pipe (and not putting much effort into making the dream a reality.)

A fantastic notion or vain hope, as in I'd love to have one home in the mountains and another at the seashore, but that's just a pipe dream. Alluding to the fantasies induced by smoking an opium pipe, this term has been used more loosely since the late 1800s. A pipe dream is a fantastic hope or plan that is generally regarded as being nearly impossible to achieve. The term derives from the opium pipe, and dates to the late nineteenth century when opium smoking was common in the United States. More specifically, the term derives from the euphoric optimism that is one of the effects of smoking high quality opium. Depending on how much opium is smoked, intoxication may last from eight to twelve hours. During this time smokers go through a period of euphoria followed by a more relaxed state of contentment and well being. Beginning in the late nineteenth and early twentieth centuries, popular literature and music began using the term "pipe dream" to describe any idea or plan whose probable outcome would never reach initial expectations. http://www.answers.com/pipe%20dream Meaning - An unrealistic hope or fantasy. Origin: The allusion is to the dreams experienced by smokers of opium pipes. Opiates were widely used by the English literati in the 18th and 19th centuries. Samuel Taylor Coleridge was one of the best known users, and it would be difficult to claim that the imagery in surreal works like Kubla Khan owned nothing to opium. Lewis Carroll, although not known to be an opium user himself, makes clear allusions to drug use in Alice's Adventures in Wonderland. Sir Arthur Conan Doyle has his hero Sherlock Holmes visit an opium den - although that was for research rather than consumption. It's strange then that 'pipe dream' comes from none of these sources but has an American origin. The early references to the phrase all originate from in or around Chicago. The earliest I have found is from The Chicago Daily Tribune, December 1890: "It [aerial navigation] has been regarded as a pipe-dream for a good many years." The first that associates the phrase with opium smoking is from The Fort Wayne Gazette, September 1895: "There are things taking place every day in Chicago which are are devoid of rational explanation as the mysterious coinings of the novelist's brain. Newspaper men hear of them, but in the rush for cold, hard facts, the 'pipe stories', as queer and unexplainable stories are called, are at a discount. Were it not for this the following incident, which can be verified by the word of several reputable men, would have long ago received the space and attention it merits instead of being consigned to the wastebasket as the 'pipe dream' of an opium devotee." [The piece goes on to describe an incredible story, apparently believed by the reporter, of a mystic incident in which a man foretells in detail the suicide of another man. It rather makes one wonder what the reporter had been smoking] In his 1896 play, "Artie - A Story of the Streets and Town", the American columnist and playwright George Ade penned this line: "But then I was spinnin' pipe dreams myself, tellin' about how much I lose on the board and all that." It seems clear that that Ade would have expected his audience to have prior knowledge of it. He goes to no effort to explain it in the play and the meaning wouldn't have been clear otherwise. http://www.phrases.org.uk/meanings/283700.html "Pipe dream," meaning an unrealistic or fantastic notion, plan or expectation, does not come from smoking hashish in a hookah. "Pipe dream" arose as a comparison of someone's loopy plan or perception to the kind of fantastic vision experienced by opium addicts, who, once addicted to smoking the narcotic, were said to be "on the pipe." Opium smoking was not uncommon among the educated classes in Britain during the 18th and 19th centuries, providing, for example, the dream-like imagery of Samuel Taylor Coleridge's 1816 poem "Kubla Kahn" ("In Xanadu did Kubla Kahn a stately pleasure dome decree…"). The use of "pipe dream" to mean "fantastic or silly idea" has been found in print around 1895, but was probably current in speech long before then. However, and this is a great big "however," the fact that "pipe dream" originally referred to opium does not make it a "drug reference" today. "Pipe dream" has been in common use for more than 100 years and has long since lost any connotation of illicit behavior. You are correct. Your client needs to "just say no" to paranoia. http://www.word-detective.com/042702.html#pipedream

The other answers are wrong. Mine is the correct one. Samuel Heatherstump was a villager outside of London where the king had one of his many castles. Samuel's job was to clean the waste from the royal chamber pot. He hated his job, hell who wouldn't. He envisioned a system where the waste would be carried away by a system of pipes and conduit. His friends laughed at him and told him that his "dream of pipes" was crazy. Samuel never gave up and eventually turned his "pipe dream" into reality.

Most sources put it's origins down to smoking Opium (obviously through a pipe) and it's subsequent illusions. The first recorded written example was from a George Ade Play in 1896. He made no referance as to it's meaning but that was in Chicago. Source = http://www.eduqna.com/Words-Wordplay/2963-4-words-wordplay.html

"pipe dream" comes from china. when the english introduced opium to the chineese. when they smoked they would have vivid dreams. "dreams from the pipe".

There IS a third possibility. Some say it comes from being mugged from behind. BOING! Pipe comes down, you fall unconscious, and the wallet is taken. What you dream then is a pipe dream. Some say. I'm only sayin'.

It's referring to a opium pipe. (sorry, out of points)