Honorary degrees appear to have arisen out of the practice of granting dispensations from certain particular academic requirements, a practice which is as old as the University itself.
The earliest honorary degree (in the sense which we would understand it today) appears to have been offered to Lionel Woodville in 1478 or 1479. Woodville, Dean of Exeter and the brother-in-law of Edward IV, appears to have already held the degree of Bachelor of Canon Law; the University offered to confer the degree of Doctor of Canon Law on him without the usual academic exercises. It was thus an offer to dispense with the usual requirements, but was apparently unsolicited and clearly an attempt to honour and obtain the favour of a man with great influence. Woodville was shortly afterwards elected Chancellor of the University, a post he held until the death of Edward IV in 1483.
Other early recipients of honorary degrees include John Boxhall, Dean of Windsor and Secretary of State to Queen Mary (1558), and Thomas Young, Archbishop of York (1564). These were not conferred at ceremonies in Oxford, but by representatives of the University who visited the recipient, usually in London.
The first honorary degrees to be awarded at a ceremony in Oxford appear to be those conferred on the Earl of Oxford and eleven others who received the MA on 6 September 1566 on the occasion of the visit of Queen Elizabeth to Oxford; it is probably not a coincidence that the office of Public Orator was first permanently established in 1564. Eight MAs were awarded at the incorporation of the Earl of Essex in 1588, and royal visits in 1592 and 1605 were also occasions for the honouring of members of the visitor's court.
The award of degrees to prelates, magnates and nobles honoris causa is provided for in the Laudian Statutes of 1634, but the earliest use of the expression honoris causa does not occur in the records of degrees conferred until 1651 (OUA NEP/supra/Reg T, p150).
When Charles I moved his court to Oxford in 1642 the University was prevailed upon by the King to award about 350 honorary degrees (in all faculties, including doctorates where applicable) between November of that year and the following February. The University responded by presenting the King with a petition arguing that the practice of conferring large numbers of honorary degrees was damaging to the University: not just to its reputation as a seat of learning, but also financially. It asked the King not to present any scholar for a degree unless he was 'capable by our Statutes, & give Caution to performe his Exercises, and pay all usual fees' (OUA NEP/supra/Reg Sb, pp21-2). The King agreed to the request.
This information is taken from Oxford University Archives: http://www.oua.ox.ac.uk/enquiries/hondegrees.html