THE farming industry has endured reduced margins and rising costs over the past five years, but, with the exception of the dairy sector, there is a mood of cautious optimism.

The price of cereals is on the rise, cattle prices are at their best levels for almost 20 years, and sheep producers believe better times may lie ahead.

However, John Taylor, director of agriculture with Bank of Scotland Corporate, yesterday warned farmers not to get carried away by a recent upturn in their fortunes.

"There is no doubt that 2006 has been a better year for farmers, but there are still challenges ahead. Not the least of which is the huge increase in the cost of inputs. Oil-related input prices have risen by more than 78per cent since 1999. That has put a huge squeeze on margins.

"To take that back to basics, red diesel (the fuel used in farm machinery with a considerable tax relief) rose from 18.9p per litre in 2000 to almost 40p per litre earlier this year. The cost of nitrogenous fertilisers has also risen by over 50per cent in the last five years."

Scottish farmers owe the clearing banks GBP1.2bn, but for the most part this is well secured on the back of high land values.

However, according to Ed Massey, an economist with Bank of Scotland, farmers should consider their lending options.

He said: "Too many think short term, but the reality is that it is now cheaper to lock into 10-year deals rather than those covering just five years. Base rates are soon expected to rise to 5per cent, but on a loan of GBP100,000 that will see interest payments come close to GBP411 each month, instead of the current GBP370. Surely it is better to take a long-term deal and repay the capital."

Another factor to be considered is that if the Bank of England does act, base rate concerns will increase over the balance between the euro and sterling. At present, the euro is worth 67p, but that rate will surely fall and that will make UK exports of beef, grain and sheep meat less competitive throughout the European Union. There is little that farmers can do directly, other than to opt to receive their annual single farm payment cheque in euros. Bank of Scotland, along with all the major financial houses, is more than willing to make that facility available to its farming clients.

Back on the farm, Taylor conceded that there are few signs of major investments in new capital equipment. "Farmers are being cautious - new pick-up trucks and balers are being bought, but very little sign of a major spend in the heavy duty stuff of potato machinery and milk parlours."

Asked specifically what he thought of the future for Scotland's 1200 dairy farmers, who have seen the ex-farm price of milk fall from almost 19p per litre in 1999 to barely 17p this year, Taylor's response was sanguine.

"At current levels, it is difficult to see how many farmers are making a profit. Maybe they should seek to add value, but that is easier than it sounds. There is a clear polarisation of views between the supermarkets, who are striving to drive down retail prices, and farmers, who obviously need more to survive.

"Surely it is time for everyone in the milk sector to sit around a table and talk it through.

"No-one wants to preside over the death knell of the Scottish dairy industry."

The bottom line is that the banks will continue to support Scottish agriculture, but it will be up to individual farming businesses to prove that they are worthy of that backing.

The year of 2006 will be regarded as pivotal in that it will allow some to retire with both dignity and cash, but also provide an opportunity for those who have the nerve to face the new challenges.