I've made soakers from Malabrigo (mmmm!) and Knitpicks Merino Style. Both are very soft. Of course they pill a lot, but that's the nature of merino. :D I know a lot of people use Cascade 220 also. Not quite as soft, but not as pilly.
I don't cloth diaper (Dh was not on board
) but I have lots of frends who do...from what I understand you only need to lanolize every month or two. I don't think you need to lanolize befor ethe first wearing -- the wool should have enough lanolin in it (before washing) to be repellent.