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Spell penetration reduces the target's resistance to your spells; it is a different mechanic from spell hit rating. Spell penetration only works against targets with resistances, and will not reduce resistances below zero. Due to it's implementation, it is primarily a PvP-oriented stat.
Spell penetration typically is intended to help casters against players (PvP) who wear resistance gear or are buffed with extra resistance, such as Mark of the Wild. In PvE, targets of a higher level than the caster have a base resistance (2% of mitigation per level difference) which cannot be overcome by spell penetration nor by any other stat. Otherwise, very few mobs and raid-level bosses have a substantial amount of resistance to overcome.
In Mists of PandariaThis section concerns content exclusive to Mists of Pandaria.
Spell penetration is being removed as a stat and mechanic in Mists of Pandaria according to Ghostcrawler (Greg Street) because it is only necessary if the resistance mechanic exists, but resistance is going away also.
The formula for spell penetration is quite simple. Each point of spell penetration negates one point of a target's resistance. Spell penetration cannot reduce a target's resistance below zero. The following equation gives effect of spell penetration on resistance, where P is the caster's spell penetration, and Rb is the target's base resistance. Here, the min() function means the minimum of two values - in this case, it shows that spell penetration greater than a target's base resistance has no effect.
R = Rb - min(P, Rb)
For example, a level 70 player with 30 spell penetration casts a fire spell at another level 70 player buffed with 40 fire resistance. The spell resist check will be done as if the target only had 10 fire resistance. A level 70 player with 100 spell penetration casting at the same target will have his fire spell's resist check done as if the target had zero fire resistance (not -60).
For additional resistance due to level difference, spell penetration has no effect. In this equation, Lt is the target's level and Lc is the caster's level. For more details on this equation, see the resistance article.
R = Rb + max((Lt - Lc) * 5, 0) - min(P, Rb)
For example, A level 70 player casts a fire spell at a level 73 raid boss with no innate resistance. The level difference is 3, so the raid boss has effectively 15 resistance to all schools against the level 70 caster. No matter how much spell penetration the caster has, his spell's resist check will always be done as if the target had 15 resistance.
Increasing Spell Penetration
The following increase spell penetration:
Using Spell Penetration
Especially in PvP, it is difficult to find a well-balanced amount of spell penetration. Against targets with no resistance, it has no effect (and as such is wasted). However, against targets with resistances, spell penetration is a powerful and, in terms of item values, cheap stat. Ideally, a caster should have exactly as much spell penetration as necessary to lower the target's resistance to zero.
In PvP, good spell penetration values are 97 (to counter Mark of the Wild and/or Blessing of Kings), and 142 (to counter various only self-cast resistance buffs, such as the Mage's Mage Armor); these are usually enough. 97 will often do for 'occasional' PvP.
In PvE, where only few mobs have resistances, especially with Curse of Elements active, spell penetration's value is situational at best. The Hungarfen in Heroic Underbog, for example, have some Nature Resistance that Spell Penetration is useful against, and the Greater Lava Spiders in Searing Gorge have some Fire Resistance. It has been estimated that Rage Winterchill has approximately 200 Frost Resistance and that Supremus has approximately 200 Fire Resistance. Since neither of these fights have a challenging time requirement, stacking enough spell penetration to compliment the curses certainly isn't mandatory but will noticeably improve individual performance.
Paladins actually need no spell penetration since the Holy school of magic has no resistance at all, in PvP or otherwise. For Discipline or Holy priests, spell penetration is not nearly as useful as it is for other casters, but since some critical PvP spells belong to the Shadow school (e.g. Shadow Word: Pain, Psychic Scream) it isn't completely useless.