Nightmare Fuel

Nightmare Fuel is a Refined Item crafted with 4 Dark Petals. A Prestihatitator is required to unlock the recipe. It is also dropped by Beardlings, Crawling Horrors, and Terrorbeaks; dropped when a Touch Stone breaks; and has a slim chance to be dug up from Graves. It can be used to make several Magic items.

Gathering
When a character's Sanity decreases below 40% of their maximum (Ex: 60 for wes, varies for WX-78 based on the upgrade level), all the Rabbits change into Beardlings and can be killed to gather Nightmare Fuel (along with Monster Meat and Beard Hair). An easy way to do this is by trapping a large number of Rabbits and then lowering Sanity to 80, after which they can all be murdered all at once while in inventory. However, be careful as this is liable to trigger the Krampus by advancing the player's naughtiness level beyond the threshold.

Alternatively, Nightmare Fuel can be acquired by killing Hallucinations. Crawling Horrors and Terrorbeaks trigger and get damaged by Tooth Traps, letting the player gather Nightmare Fuel relatively safely. Crawling Horrors are easier to deal with than Terrorbeaks; the latter don't appear until Sanity is very very low, so it's possible to kill Crawling Horrors one at a time.

A more safe and simple way to get Nightmare Fuel is to capture Bees and then release them at an Evil Flower patch. This will eventually cause more Evil Flowers to spawn, which can easily be crafted into Nightmare Fuel.

Trivia

 * The term "nightmare fuel" is a common phrase on the Internet used to describe works of fiction, or scenes therein, that are extremely likely to disturb and/or frighten the audience.