I just reinvented this idea, and was promptly shown this one. I'll add my original post here instead:
You can go about this in two ways:
1) Oily rag
You need a new item, an oily rag. This is created by dipping a bandage in a potion of oil. If the rag is later 'u'sed with a wooden stick, you get a torch.
2) Dry torch
Instead of a new item, you can have a new property of the regular torch: dry. You can create a dry torch by wrapping bandages around a wooden stick. This would show up in the inventory as "torch (dry)". This torch can be dipped in a potion of oil to create a new torch.
Common to these are that you get a new torch with a known amount of fuel left. The amount of fuel could be affected by the B/U/C status of the items involved, or perhaps only of the oil. The torch itself should have the same B/U/C status as the wooden stick.
And I do think that oil should be necessary in some way.