While "smell" is the more common verb used for perceiving odors, "observed" is also grammatically correct, especially if you want to emphasize a more deliberate and analytical perception.
Here are some examples of how it could be used:
* "I observed an unusual odor coming from the basement." (This emphasizes a deliberate act of noticing and potentially investigating the smell.)
* "The scientist observed a faint odor of sulfur in the air." (This highlights the scientific and careful way the odor was perceived.)
However, in everyday conversation, "smell" would likely be the more natural choice.