Smail added a 68 to his opening-round 66 to finish the day at 6-under, and holds a one-stroke advantage over O'Malley (66) and overnight co-leader Scott Hend (70). Four-time winner Bob Charles is fourth at 4-under following a second successive 68.
Three shots removed from Smail are another six players at 3-under - Australians Paul Sheehan (72), Nathan Gatehouse (71), David Bransdon (69) and Craig Jones (70), Kiwi Steve Alker (70) and Swede Marcus Norgren (67).
Meanwhile, American David Gossett slipped into a tie for 42nd. The 1999 U.S. Amateur champion began the day just two strokes off the lead at 3-under, but fell to a 75 on Friday.
Smail scored back-to-back birdies at five and six to go to 6-under and the solo lead after seven holes, but consecutive bogeys at the eighth and ninth holes stalled his early momentum.
The Kiwi responded well though, recovering one of the lost strokes with a birdie at the 12th, and then finished his round on a good note with his fourth birdie of the day at the last.
'I felt a lot better today,' Smail said after his round. 'I just really played the percentages and tried to keep it short of the hole most of the time and try to leave myself some easy putts because there's some pretty fast ones out there.'
O'Malley, who was the last Australian to win the NZ Open, coincidentally here at The Grange, scored back-to-back birdies at three and four to move to 3-under by the turn.
Two more birdies at the 12th and 16th carried O'Malley to within one of Smail and saw him finish with his flawless 4-under 66.
After dropping a shot early, Hend recovered the lost stroke and picked one up to move to 6-under and the lead, but was only able to finish with an even-par round courtesy of a birdie at the ninth, after carding successive bogeys at seven and eight.
Starting the day 2-under, Charles began poorly with consecutive bogeys at the third and fourth holes, but successive birdies at six and seven got his round back on track.
Building on that momentum, the 64-year-old added birdies at the 11th, 12th and 16th holes. A bogey at 14 the only thing preventing him from also climbing to within one of his compatriot Smail.
Eight more players are tied for 11th at 2-under, including Victorian John Wade - who shot the round of the tournament thus far, a 6-under 64 that included an eagle, five birdies and a bogey - Euan Walters (70), and Englishman Roger Chapman (66).
Tournament favorite Michael Campbell's title defense remains intact, but the world No. 16 will have to continue the improvement that saw him recover from 5-over through the front nine to 3-over with a 72 if he is to contend over the weekend.
With the cut set at 3-over, 143, 70 players survived and will continue over the weekend.
Among those leaving early are Brett Rumford, who despite a 69 didn't do enough to recover from his Thursday 77, and Phil Tataurangi, who likewise was unable to recover sufficiently from his opening 79.
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