This is correct, not all media items have an original image. But this one should otherwise we wouldn't try to use it.
You should have an "original" image if the image has been watermarked. We do this so that if you decide to remove the watermark or change the watermark then we can apply it to the original, pre-watermarked image.
The error suggests that the original file is missing from your server. It's difficult to say whether it was missing prior to version 2 or has gone missing since.
It is looking for the file in internal_data/xfmg/original/0/.... In versions prior to XFMG 2.0 the original files were stored in a slightly different location, specifically internal_data/xengallery/originals/0/... but the upgrade should have gracefully handled moving them.
You may wish to see if you can locate the missing files.
If you cannot then there's not a great deal we'd be able to do.
I am making a small change in XFMG 2.2.1 which will allow the "Unwatermark image" feature (in inline moderation and batch update media) to remove the "watermarked" flag so we no longer consider the image to be watermarked.
Further to that I've added code to fallback to the normal image if the original cannot be found so the set as avatar function should just work without error.
Though please note: missing files are unexpected so it would be best if you can dedicate some time to figure out why that might have happened.
Thank you for reporting this issue, it has now been resolved. We are aiming to include any changes that have been made in a future XFMG release (2.2.1).
When unwatermarking images if the original data path cannot be found, remove the watermark flag. Also fallback to the non-original image in some cases in the unlikely event that the original image cannot be found.